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Master Thesis
2014
The Behaviour of Management in a Mandatory Audit Firm Rotation Setting (An Analysis of the Magnitude of the Use of Earnings Management)Author: Adrian vandrașSTUDENT NUMBER: 387535 DATE: 25.08.2014SUPERVISOR: E.A. DE KNECHT RACO-READER: DR. SC. IND. VAN DER BOOM
Erasmus University RotterdamERASMUS SCHOOL OF ECONOMICSACCOUNTING, AUDITING AND CONTROL (FEM11112)
ERASMUS UNIVERSITY ROTTERDAM
ERASMUS SCHOOL OF ECONOMICS
Accounting, Auditing & Control Master Programme
The Behaviour of Management in a Mandatory Audit Firm Rotation Setting (An Analysis of the Magnitude of the Use of
Earnings Management)- Evidence from Italy –
Abstract
Special thanks to Mr. E. A. de Knecht RA, for the contribution to the development of this thesis. His constant feedback and support were essential during the writing process.
In order to restore the confidence in the audit profession, the Dutch Parliament has imposed a
mandatory audit firm rotation rule, which will be implemented in the Netherlands starting from 1st of
January 2016. Because tension exists in prior research regarding the effects of mandatory audit firm
rotation, answering the research question of this thesis provides valuable insights for both academics
and practitioners. This thesis investigates the effect mandatory audit firm rotation has on the
behaviour of the management in terms of earnings management. The sample used for testing this
relationship consists of 357 firm-year observations from 44 unique Italian public listed firms, during
the period 2005-2013. In Italy, mandatory audit firm rotation is active since 1974, and consequently
provides with a proper setting for investigating this relationship. In addition, this setting increases
the external validity of this thesis. Two hypotheses are formulated for answering the main research
question. Hypothesis 1 investigates the correlation between audit firm tenure and the amount of
discretionary accruals; this hypothesis is confirmed, indicating a significant positive correlation, in
contrast with the findings from other studies in prior research, which show evidence for a negative
correlation. Hypothesis 2 investigates the effect of the auditor rotation on the amount of
discretionary accruals in the first year after the rotation, compared to the year prior to the rotation;
no conclusive results derived from testing this hypothesis, consequently hypothesis 2 is not
accepted, nor rejected.
Table of Contents1. Introduction.........................................................................................................................1
1.1. Motivation....................................................................................................................2
1.2. Research Question........................................................................................................3
1.3. Methodology................................................................................................................4
1.4. Limitations...................................................................................................................5
1.5. Structure of the Thesis..................................................................................................6
2. Background..........................................................................................................................7
2.1. Mandatory Audit Firm Rotation...................................................................................7
2.1.1. What is the theoretical content of mandatory audit firm rotation?...........................7
2.1.2. Evolution of Mandatory Audit Firm Rotation..........................................................7
2.1.3. MAFR – Potential Advantages vs. Potential Disadvantages....................................9
2.1.4. Advocates vs. Opponents of MAFR: What are the positions of the regulators and of the dependent bodies?.......................................................................................................10
2.2. Earnings Management................................................................................................11
2.2.1. Defining the term Earnings Management...............................................................11
2.2.2. Accrual Earnings Management..............................................................................12
2.2.3. Real Earnings Management....................................................................................15
2.2.4. Incentives for the Use of Earnings Management....................................................16
2.2.5. What are the positions of the regulators and of the dependent bodies?.................17
2.3. Agency Theory...........................................................................................................17
2.4. Positive Accounting Theory.......................................................................................18
2.5. Legitimacy Theory.....................................................................................................19
2.6. Summary....................................................................................................................20
3. Models for Detecting and Measuring the Use of Earnings Management..........................21
3.1. Jones Model................................................................................................................21
3.2. Modified Jones Model................................................................................................23
3.3. The Industry Model....................................................................................................24
3.4. The Healy Model........................................................................................................24
3.5. The DeAngelo Model.................................................................................................24
3.6. McNichols Model.......................................................................................................25
3.7. Forward Looking Model............................................................................................25
3.8. Performance Matched Model.....................................................................................25
3.9. Which earnings management measurement models to test the hypotheses in this thesis will be used?...............................................................................................................26
3.10. Summary.................................................................................................................26
4. Evidence from Prior Research...........................................................................................28
4.1. The relationship between MAFR and the auditor independence...............................28
4.2. The relationship between MAFR and the use of earnings management analysed in two steps: (1) the effect of MAFR on the audit quality and (2) the effect of the audit quality on the use of earnings management......................................................................................29
4.2.1. The effect of MAFR on the audit quality...............................................................30
4.2.2. The effect of auditors’ behaviour on the use of earnings management..................31
4.3. The relationship between the audit tenure and the use of earnings management......33
4.4. Comparative Assessment of the Prior Literature.......................................................36
4.5. Summary....................................................................................................................37
5. Hypotheses.........................................................................................................................38
5.1. Hypotheses Development...........................................................................................38
5.2. Summary....................................................................................................................40
6. Research Design................................................................................................................41
6.1. Research approach......................................................................................................41
6.2. Research Methodology...............................................................................................42
6.2.1. Measuring the Amount of Discretionary Accruals (the dependent variable).........42
6.2.2. Measuring the length of the audit tenure (the independent variable).....................43
6.2.3. Control variables.....................................................................................................44
6.2.4. Testing the hypotheses............................................................................................45
6.3. Validity framework....................................................................................................45
6.4. Sample........................................................................................................................48
6.4.1. Sample Selection....................................................................................................48
6.4.2. Data Collection.......................................................................................................50
6.5. Summary....................................................................................................................50
7. Results...............................................................................................................................51
7.1. Quality Tests..............................................................................................................51
7.1.1. Normal Distribution of the Sample........................................................................51
7.1.2. Outliers...................................................................................................................52
7.1.3. Homoscedasticity....................................................................................................53
7.1.4. Multicollinearity.....................................................................................................54
7.2. Earnings Management Model Results........................................................................55
7.3. Hypotheses Testing Results.......................................................................................57
7.3.1. Hypothesis 1...........................................................................................................57
7.3.2. Hypothesis 2...........................................................................................................58
7.4. Comparison with Prior Research................................................................................59
7.4.1. Comparison to Davis et Al. (2000).........................................................................59
7.4.2. Comparison to Myers et Al. (2003)........................................................................61
7.4.3. Comparison to Chen et Al. (2008)..........................................................................62
7.5. Summary....................................................................................................................62
8. Conclusions.......................................................................................................................64
8.1. Concluding Remarks..................................................................................................64
8.2. Limitations.................................................................................................................65
8.3. Recommendations for Future Research.....................................................................66
References.................................................................................................................................67
Appendices................................................................................................................................71
Appendix 1: Summary table of the literature review............................................................71
Appendix 2: Sample Information..........................................................................................74
Appendix 2.1: Sample description........................................................................................74
Appendix 2.2: Auditors’ distribution in the sample..............................................................74
Appendix 2.3: Tests for normality........................................................................................75
Appendix 3: Estimating Discretionary Accruals..................................................................77
Appendix 4: Testing the Hypotheses....................................................................................79
Appendix 4.1: Hypothesis 1 results......................................................................................79
Appendix 4.2: Hypothesis 2 results......................................................................................81
1. Introduction
The purpose of this thesis is to explain the influence of the mandatory audit firm rotation
(MAFR) on the magnitude of the use of earnings management in financial reporting. After the
widespread major fraud scandals, from Enron to WorldCom and beyond, or the Dutch Ahold,
the audit environment and the stakeholders involved started to analyse and debate the auditor-
client relationship. Questions like “In which way could audit quality be improved?”, and “In
which way could the auditor’s independence be better protected?” emerged, and mandatory
audit firm rotation became a hot topic in the auditing profession. According to Healy and Kim
(2003), a mandatory audit firm rotation rule potentially restores the confidence in the
regulatory system and in the auditing profession, as was found in Italy (Healey & Kim, 2003).
A mandatory audit firm rotation setting requires companies to rotate their auditor after a
certain period of time. Currently, the only European country that has an active MAFR rule is
Italy, in which auditors must be rotated every nine years for public listed companies. Other
countries that use a MAFR rule are Brazil, China, India, Indonesia, Pakistan, Philippines,
Singapore and South Korea. In the U.S., MAFR was not implemented. The United States
General Accounting Office (GAO), in the November 2003 published “Required Study on the
Potential Effects of Mandatory Audit Firm Rotation”, concluded that “GAO believes that
mandatory audit firm rotation may not be the most efficient way to strengthen auditor
independence and improve audit quality considering the additional financial costs and the
loss of institutional knowledge of the public company’s previous auditor of record, as well as
the current reforms being implemented. The potential benefits of mandatory audit firm
rotation are harder to predict and quantify, through GAO is fairly certain that there will be
additional costs” (GAO, 2003, p. 1).
On the other hand, in the European Union the European Commission has proposed mandatory
audit firm rotation for all European listed companies (European Commission, 2011).
Moreover, the Dutch Parliament has recently approved a MAFR rule in The Netherlands,
which will be implemented starting from 1st of January 2016 for public-interest entities and
will require the rotation of auditors every eight years, with a cooling-off period of two years,
after which the previous auditor may be mandated again (Staten-Generaal, 2012). However,
the eight years period is currently subject to discussion and could be lengthened to ten years
(Accountancynieuws, 2014).
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In this thesis, the relation between the mandatory audit firm rotation and the management’s
behaviour in terms of the use of earnings management will be investigated. The content of the
term “earnings management” in financial reporting implies “a purposeful intervention in the
external financial reporting process, with the intent of obtaining some private gain (as
opposed to, say, merely facilitating the neutral operation of the process)” (Schipper, 1989, p.
92). A more extensive description of the term “earnings management” will be pledged in the
succeeding part of this chapter. As for the theoretical explanation of the use of earnings
management and the methods used to determine and measure it, a thorough literature review
will be provided in chapters two, three and four.
The main driver for this thesis is the current debate about the forthcoming MAFR in the
Netherlands and its potential consequence for the management’s behaviour in terms of the use
of earnings management in the annual financial reporting. Next, a brief introduction to the
topics of MAFR and the use of earnings management will be presented. The succeeding parts
of this chapter include stating the research question, commenting the sample to be used in the
empirical research, the relevance and the limitations of this thesis. Finally, the chapter will
end with the presentation of the structure of the thesis.
1.1. Motivation
Regulators expect auditor’s independence in a mandatory audit firm rotation setting should
increase both the independence in mind and the independence in appearance. Consequently,
this expectation indirectly creates a higher degree of the audit quality. The purpose of this
thesis is not to determine the effect MAFR has on the audit quality, but to investigate the
relationship between MAFR and the magnitude of the use of earnings management. However,
a literature review regarding the influence on the audit quality will be presented later in this
thesis, in which the advocates of MAFR vs. critics of MAFR situation will be presented. It is
essential to acknowledge that the use of earnings management has an effect on the
information usefulness in the annual financial statements.
Prior research has found that a MAFR setting has an effect on the auditor’s behaviour. Based
on different audit tenures that were analysed, a change in the auditor’s behaviour occurs; this
can generate levels of higher or lower audit quality. Although it is not the purpose of this
thesis to analyse the effect of MAFR on the auditor’s behaviour, but on the management’s
behaviour in terms of the use of earning management, chapter two and chapter four include
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some comments about this change in the behaviour of the auditor, but no thorough research is
performed concerning this matter.
The auditing profession implies several aspects that could influence the magnitude of the use
of earnings management in a MAFR environment. Certain characteristics of the audit
profession could involve an either higher or lower degree of the use of earnings management,
which creates the necessary tension that motivates to perform this research.
In their paper, Davis et Al. (2000) found evidence that auditors with long-term relationship
with their client are more likely to “allow” the management of the client greater flexibility in
managing the published earnings through the use of accruals (Davis, Soo, & Trompeter,
Auditor Tenure, Auditor Independence and Earnings Management, 2000). Accordingly, the
expectation is that in the case of auditors with longer tenure, the magnitude of the use of
earnings management is higher than in the case of auditors in the first years of the
engagement.
Other relevant aspects of the audit profession will be presented later in the second chapter of
this thesis.
1.2. Research Question
This thesis aims to answer the next research question:
“What is the effect of the mandatory audit firm rotation rule on the management’s behaviour
in terms of the use of earnings management?”
In order to create a coherent and straightforward structure of the thesis, corresponding to the
chapter structure, the next sub-questions are formulated:
Sub-question 1
“What are the definition and the background of the mandatory audit firm rotation and
earnings management?
Sub-question 2
“What are the positions of the regulators and the dependent bodies on these topics?”
Sub-question 3
“Which models in prior research are used for detecting and measuring the use of earnings
management?”
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Sub-question 4
“What does evidence from prior research communicate so far about the effect MAFR has on
the management’s behaviour in terms of the use of earnings management?”
Sub-question 5
“Based on the research question and prior literature, in order to answer the research
question which hypotheses will be formulated?”
Sub-question 6
“Which research design will be used to test the formulated hypotheses and to answer the
research question?”
Sub-question 7
“What do the statistical results of the empirical research present about the studied
relationship?”
Sub-question 8
“Which conclusions are derived from the analysis of the statistical results and the comparison
with results of prior research?”
To answer the research question, an archival study will be conducted, in which data will be
analysed from firms in a mandatory audit firm rotation setting.
1.3. Methodology
Concerning assessing the theoretical relation between mandatory audit firm rotation and
earnings management and for evaluating the regulators’ position about these topics a literature
study will be performed.
This thesis investigates the effect of the MAFR on the magnitude of the use of earnings
management. The model which will be used to empirically test the hypotheses, developed for
the purpose of answering the research question, will be chosen in the third chapter of this
thesis after an assessment of the models used in prior research for detecting and measuring the
use of earnings management.
The models relevant to this thesis have an approach that relies on the measurement of
accruals. First, it is essential to distinguish between the two types of accruals: discretionary
accruals and non-discretionary accruals. Discretionary accruals reflect the management’s
accounting choices and mark the behaviour of the management in terms of earnings
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management: in order to manage the published earnings, discretionary accruals can be
manipulated by the management, by exercising their discretion regarding these accruals. This
way, earnings can be managed either upwards or downwards by the management, depending
on their incentives and their objectives. On the other hand, non-discretionary accruals are
considered normal expected accruals, which are directly dependent on the company’s
operations or on the external factors. A model will be used to estimate the discretionary
accruals, which will be the proxy for the use of accrual earnings management in this thesis.
Most papers in the scientific literature regarding mandatory audit firm rotation are based on
settings in which mandatory rotation does not exist. However, in order to achieve a better
understanding of the management’s behaviour in such an environment it is essential to
conduct the empirical analysis by acquiring relevant data from a real and appropriate MAFR
setting in this thesis. Consequently, this thesis will test the relationship in a real MAFR
setting: Italy. According to Cameran et al. (2012), the mandatory audit firm rotation rule in
Italy was enforced in 1975 and it allowed an auditor term to be renewed every three years up
to a maximum tenure of nine years (Cameran, Prencipe, & Trombetta, 2012). However, the
Italian regulation on MAFR in 2006 has been revised by dropping the option to replace the
auditor at the end of each three years period.
In order to test the hypotheses, a sample from the targeted population will be selected. To
select all Italian public listed companies that have all the needed information available for the
specified period the Compustat Global database will be used. For the purpose of this study,
the intention is to focus on the period 2006 up to and included 2013, i.e. from the moment the
MAFR rule was modified until present time. However, the year of 2005 will also be included
in the sample, since data from the previous year will be necessary for the empirical tests.
Consequently, the timeline used in the thesis will be 2005 up to and included 2013.
To perform the statistical analysis with the purpose of testing the hypotheses of this thesis,
using a cross-sectional model, SPSS software will be used.
1.4. Limitations
In a regime of mandatory audit firm rotation, the auditor is aware what the maximum period
of the engagement is, which implies a potential change in the auditor’s behaviour in the last
years of the engagement. Testing the relationship between MAFR and the management’s
behaviour in terms of the use of earnings management in a real MAFR environment, controls
for the potential bias that could result from tests in a non-mandatory rotation setting, and
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improves the quality of this thesis’ results. However, due to the unavailability of data in the
Compustat Global database for the period before 1987 limitations arise. In addition, the
limited number of public listed companies in Italy can be considered a limitation of this study.
To address this limitation, an extended period will be used for the statistical tests, i.e. 1987-
2006, and consequently, the internal validity is enhanced.
Detecting and measuring the use of earnings management can rather be a difficult task. The
model to be used in this thesis involves estimates and is considered to have low test power. In
addition, the model tests only quantitative data; consequently, since no qualitative information
is used to confirm that the findings accurately reflect the reality, e.g. direct information from
managers through interviews or surveys, the model could be deficient in proving causality.
Other limitations could result from the specific characteristics of the country used in the
testing, e.g. culture, risk appetite, litigation etc., which can downgrade the possibility to
generalize the results to the entire population. In addition, correlated omitted variables could
exist that are not included in the model through control variables.
1.5. Structure of the Thesis
The remainder of the thesis is structured as follows.
Chapter two presents the answer on the first two sub-questions and accordingly presents the
background of the MAFR and the use of earnings management.
The third chapter presents the answer to the third sub-question and consequently presents the
models used in prior literature to measure the use of earnings management.
Chapter four answers the fourth sub-question and describes the empirical findings from
previous research that contribute to answering the research question.
Chapter five, in accordance with sub-question five, states the hypotheses.
The sixth chapter provides the answer to sub-question six, by presenting the research design
to be used for testing the hypotheses.
Chapter seven answers the seventh sub-question and displays the results of the empirical
research.
Finally, the results of the empirical research will be analysed and conclusions will be derived
in chapter eight, which answers sub-question eight.
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2. Background
This chapter provides the answer to the first two sub-questions:
“What are the definition and the background of the mandatory audit firm rotation and
earnings management? and “What are the positions of the regulators and the dependent
bodies on these topics?”
In addition, this chapter underpins the understanding of these two concepts, i.e. MAFR and
the use of earnings management, by presenting three accounting theories that have an impact
on the subject of this thesis: the agency theory, the positive accounting theory and the
legitimacy theory.
2.1. Mandatory Audit Firm Rotation
By analysing the circumstances of MAFR within the United States and in Europe in this
section the evolution of the regulation and the positions of the interested bodies about the
mandatory audit firm rotation are presented, and finally, the focus will be drawn on the
Netherlands.
2.1.1. What is the theoretical content of mandatory audit firm rotation?
A mandatory audit firm rotation (MAFR) setting posits a requirement for companies to rotate
their auditor after a certain period of time. MAFR is not a standard rule and consequently the
allowed auditor-retaining period, as well as the cooling-off period, can vary. For example, as
it was signalled before in the first chapter of this thesis, Italy has a mandatory audit firm
rotation rule that involves a retaining period of maximum nine years, while in the Netherlands
will be implemented a MAFR rule for a period of eight years, which could change to ten
years.
2.1.2. Evolution of Mandatory Audit Firm Rotation
In an auditor-client relationship, an agency issue arises since auditors, i.e. agents, are being
paid by the client’s management, i.e. principals. The agency theory is further explained in
section 2.3 of this thesis. This situation potentially results in a conflict of interests for
auditors, threatening auditors’ independence and the audit quality. In order to address this
issue, efforts have been performed to increase independence of auditors, improving the audit
quality and alleviate the influence management has on the auditors.
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Lately, a worldwide debate exists about the MAFR rule, concerning whether it is an advisable
and effective measure, especially after the financial reporting scandals like Enron in 2001, or
WorldCom in 2002. One consequence of these scandals in the United Stated of America (US)
in 2002 was the implementation of the Sarbanes-Oxley Act (SOX), which re-evaluated the
role of the auditor. Substantial discussions about how auditors’ independence can be restored
have been performed, and concerning this situation mandatory rotation was one of the most
commented measures. The debate was mainly about whether mandatory audit firm rotation in
the SOX regulations should be included and whether other measures which are less extreme
would be enough in order to promise the independence of the auditors. In section 207, SOX
notified about a review study by the U.S. General Accounting Office (GAO) concerning the
potential effects of the mandatory audit firm rotation of registered public auditing firms.
Published in November 2003, the results of this study state that the GAO’s conclusions
indicate that “mandatory audit firm rotation may not be the most efficient way to strengthen
the auditor independence and to improve the audit quality considering the additional financial
costs […]” (GAO, 2003, p. 1). Consequently mandatory audit firm rotation was not included
in SOX and implicitly not implemented in the US. However, in order to address the auditors’
independence issue, and as a response to the financial reporting scandals, a measure had to be
taken. Consequently, SOX implemented a mandatory audit partner rotation rule: the partner of
a registered public audit firm needs to rotate after a period of five years of auditing the same
client, followed by a cooling-off period of another five years when the partner is not allowed
to be part of the auditing team for that client.
In Europe, on the other hand, financial reporting scandals occurred as well, like Parmalat in
Italy in 2003, or Ahold in the Netherlands in 2003. Consequently, the European Commission
proposed the requirement for public listed companies to rotate the audit partners after five
years, and rotate the audit firm after seven years. The 8th Directive enforces the audit partner
rotation in the E.U., while mandatory audit firm rotation is left for the European Union
Member States to decide whether to impose it at a national level (The European Parliament
and the Council of the European Union, 2006). Moreover, in 2011, the European Commission
has proposed the mandatory audit firm rotation for all European Union listed companies
(European Commission, 2011). Most E.U. Member States now require partner rotation. On
the other hand, Italy kept the MAFR rule active, while the Dutch Parliament approved the
implementation of a MAFR rule starting from 2016.
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In 2008, the Government Accountability Office (GAO), i.e. former General Accounting
Office which changed its legal name effective July 7, 2004, was appointed by the US
Securities and Exchange Commission (SEC) to study the issue of the MAFR rule, reaching
the conclusion that no clear evidence exists regarding the potential benefits of a MAFR rule
(GAO, 2008). However, the Public Company Accounting Oversight Board (PCAOB) issued a
concept release, in which comments on the advantages and the disadvantages of MAFR are
solicited (PCAOB, 2011).
2.1.3. MAFR – Potential Advantages vs. Potential Disadvantages
Theory provides three main advantages of the use of mandatory audit firm rotation. First, a
potential increase in the auditors’ independence is regarded. The potential increase is in both
the independence in mind and the independence in appearance. Independence in mind
represents the actual independence that is the auditor’s state of mind that allows the audit to
be conducted in such a way that the principles of independence, integrity, objectivity and
professional scepticism are respected. Independence in appearance is the perceived
independence that is how the public sees and interprets the auditors’ independence. Second,
an improvement in the audit quality is considered. DeAngelo (1981) defines audit quality as
“the market-assessed joint probability that an auditor will both (a) discover a breach in the
client’s accounting system, and (b) report the breach” (DeAngelo, 1981, p. 186). The third
potential advantage of the mandatory audit firm rotation refers to the audit capital market
competition. This advantage implies that the mandatory rotation could increase the
competition between the Big4 and the non-Big4 audit firms.
Alternatively, the potential disadvantages consist of matters regarding the increased costs
generated by the mandatory audit firm rotation. These costs arise from the necessity of the
new auditor to become familiar with the client practices in order for the audit to be properly
performed. In this situation, it is essential to distinguish between two types of costs: audit
costs, which would eventually create an increase in audit fees, and support costs for the client,
i.e. material resources and personnel assistance for the new auditor, which would ultimately
create a decrease in the client’s profitability.
A more thorough explanation of the potential advantages and disadvantages of the mandatory
audit firm rotation in the next section of this thesis is presented in which the arguments of the
advocates and of the opponents of MAFR will presented, as well as the positions of the
regulators and of the dependent bodies.
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2.1.4. Advocates vs. Opponents of MAFR: What are the positions of the
regulators and of the dependent bodies?
As signalled before, after the auditors’ independence issues have been revealed by the
financial reporting scandals, mandatory audit firm rotation has been extensively commented
worldwide. The positions of the advocates and the opponents of the mandatory rotation are
included in the review study by Raiborn et Al. (2006), who summarized the arguments of both
sides. The advocates vs. the opponents of MAFR argumentations presented next rely on this
article, by presenting their findings. (Raiborn, Schorg, & Massoud, 2006).
Advocates argue that long-standing auditors develop an involuntary “friendship” towards the
client, which would consequently affect the auditor’s judgment; advocates claim that long-
tenure auditors tend to agree with the client in matters that the auditor would not accept if the
tenure was shorter and implicitly the relationship was less familiar. This implies the potential
impairment of independence in mind. In addition, advocates of MAFR claim that even when
independence in mind is not affected, the public perception of the auditor’s independence, i.e.
independence in appearance, has to suffer. They consider that when the rotation of the audit
firms is mandatory, auditors’ independence, both in mind and in appearance, is at a higher
degree. Another pro-argument that Raiborn et Al. (2006) presented is that MAFR has the
potential to make audit firms more vocal and strict when disagreeing with certain practices
undertaken by the client. In addition, MAFR would increase the level of competition in the
auditors market, which could potentially reduce the audit fees. Finally, advocates consider
that a “fresh look” from a new auditor is likely to improve the audit quality. This claim is also
supported by the findings of other studies, i.e. (DeAngelo, 1981, p. 189), and (Deis & Giroux,
1992, p. 470) which indicate a negative relation between audit tenure and audit quality that is
the longer the auditor tenure, the lower the audit quality. In addition, because the current
auditor is aware that the successor auditor will review his work and will be more likely to
detect and disclose his errors, inefficiencies or misjudgements by MAFR the audit quality
would be improved (Raiborn, Schorg, & Massoud, 2006).
On the other hand, opponents argue that because the new auditor does not have such a
comprehensive knowledge of the client practices the mandatory audit firm rotation would
increase the audit risk and the potential of audit failures. In addition, the necessity of
becoming familiar with the client practices increases the audit costs and the client’s support
costs, which would implicitly increase the audit fees and reduce the client’s profitability and
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reduce the shareholder value. However, the findings of Healy (2004) are in contrast to this
position, indicating that the costs in the case of an audit failure would be higher than the costs
of the mandatory rotation (Healey, 2004). Another argument of the opponents of the MAFR is
that because of the increased possibility that the auditor might focus on promoting their non-
audit services to the client in the final years of the engagement instead of concentrating on
providing high-quality audit services, MAFR would decrease the audit quality. In addition,
due to the new auditors’ tendency to be overly aggressive in challenging the judgments of the
predecessor auditor, the tension between the new auditor and the client would increase.
Finally, some opponents consider that mandatory rotation would cause the new auditor to
excessively rely on the work of the predecessor auditor. However, this argument is, to a
certain extent, in contradiction with the previous one. (Raiborn, Schorg, & Massoud, 2006)
In addition, with regard to the positions of regulators and dependent bodies, Cameran et Al.
(2005) have reviewed the conclusions and findings of 26 reports by regulators or other
representative bodies from around the world. “Of the 26 reports, 22 conclude against the
benefits of the mandatory audit firm rotation and while 4 are in favour” (Cameran, Merlotti, &
DiVincenzo, 2005, p. 4).
2.2. Earnings Management
In the next subsections of this thesis, the characteristics and the content of the term earnings
management will be presented. First, by presenting several definitions available in prior
scientific research, the term “earnings management” will be explained. Next, the content of
the term earnings management will be analysed, and the distinction between accrual earnings
management and real earnings management will be presented. Finally, the incentives that
drive management to engage in earnings management and the positions of the regulators
regarding the use of earnings management will be commented.
2.2.1. Defining the term Earnings Management
Academic economic literature provides several definitions for the term earnings management,
but the most representative are the two below.
Schipper (1989) defines earnings management as:
“a purposeful intervention in the external financial reporting process, with the
intent of obtaining some private gain (as opposed to, say, merely facilitating the
neutral operation of the process). Under this definition, earnings management
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could occur in any part of the external disclosure process, and could take a
number of forms. A minor extension of this definition would encompass ‘real’
earnings management, accomplished by timing investment or financing decision
to alter reported earnings or some subset of it” (Schipper, 1989, p. 92).
Healy and Wahlen (1999) state that:
“earnings management occurs when managers use judgment in financial reporting
and in structuring transactions to alter financial reports to either mislead some
stakeholders about the underlying economic performance of the company, or to
influence contractual outcomes that depend on reported accounting numbers”
(Healy & Whalen, 1999, p. 368).
Another definition of earnings management is provided by Scott (2014), who states that
“earnings management is the choice by a manager of accounting policies, or real actions,
affecting earnings so as to achieve some specific reported earnings objectives” (Scott, 2014,
p. 156). In other words, the use of earnings management implies that managers use the
flexibility of accounting rules when recording the company’s expenses or revenues,
depending on the intention of the management: whether to manage earnings upwards or
downwards, through the use of either accruals or real activities.
Management can employ two types of earnings management: accrual earnings management
and real earnings management. An introduction of these two is presented next.
2.2.2. Accrual Earnings Management
Accruals based earnings management uses the discretion of the management in the process of
adopting accounting policies and methods and in the process of estimating figures.
Before explaining the concept of accruals based earnings management, it is essential to have
an understanding of the term “accruals”, since accruals earnings management implies the
manipulation of accruals.
Accruals can be defined as provisional components of the balance sheet that emerge due to
the fact that the principles of timing and matching are not always respected for certain
transactions. For example, a type of accrual which could indicate the presence of the use of
earnings management is the situation when one product is sold at one point, but the payment
for the sale is made at a later point in time. Total accruals can indicate whether in the financial
12
reporting the use of earnings management exists. The total accruals can be calculated based
on the next equation:
Total Earnings = Total Accruals + Net Cash Flows
It is essential to differentiate between discretionary and non-discretionary accruals (Cohen,
Dey, & Lys, 2008). Discretionary accruals are at the discretion of the management, while
non-discretionary accruals are dependent on the company’s business operations and other
environmental factors.
Accrual earnings management can now be properly commented. Roychowdhury defines
accrual earnings management as “manipulating accruals with no direct cash flow
consequences” (Roychowdhury, 2006, p. 336). Examples of accruals that could indicate the
use of earnings management can be prepaid costs or accounts receivable. The reason why
these accruals are considered as potential red flags for earnings management is because of the
assumption that management uses discretion when recognizing these items.
In the next paragraphs, several accrual earnings management techniques will be presented.
Cookie Jar Reserves
General Accepted Accounting Principles require building reserves in order to secure that
subsequent obligations can be paid (McKee, 2005). Even though these obligations are related
to events from the past, the amounts of the future expenses are unclear in most cases, and
estimates are required, since these expenses are not directly measurable. Consequently the
estimation process creates the possibility of the use of earnings management: when the actual
reserve is created at a larger amount than the estimation of the expenses a cookie jar reserve is
created. This cookie jar reserve increases the expenses and consequently decreases the
published earnings in the current period. The purpose of creating cookie jar reserves is to be
used to increase the published earnings in the future periods.
Taking a Bath
When a firm’s performance is poor during a year and it needs to report a loss, management
tends to increase the published expenses and report a larger loss because of the assumption
that one bad year is not so much harmful as more bad years are (Scott, 2014). An example of
13
“taking a bath” technique is excessive assets write-offs. Consequently, the accrual reversal
increases the probability of the subsequent profits. Scott (2014) stated that this technique
often occur during periods of organizational stress or restructuring activities, since in this
situation an opportunity arises for the management to engage in earnings management:
restructuring costs involve estimates and estimates imply discretion.
Income Minimization
This pattern is, to a certain extent, similar to taking a bath. However, it is less extreme, since it
occurs mostly by politically visible firms during periods of high profitability (Scott, 2014). In
situations like this, management undertakes accounting policies that suggest income
minimization, such as rapid write-offs of capital assets and intangibles and the expensing of
advertising or R&D expenditures. The most common motivation for minimizing the income is
the income tax consideration (Scott, 2014).
Income Maximization
Income maximization is in conformity with the positive accounting theory. Management may
use earnings management to maximize the reported income for bonus purposes, while
potential debt covenant violations in addition could be an incentive for the use of earnings
management to maximize the published income (Scott, 2014).
Income Smoothing
Income smoothing is probably the most interesting earnings management technique. Various
motivations exist concerning undertaking income smoothing practices.
Based on a contracting point of view, managers who have a risk-averse attitude would rather
have a less variable bonus stream, which implies a less variable earnings stream (Scott, 2014).
Accordingly, in order to be awarded with a relatively constant compensation, managers could
smooth the reported earnings over time. In addition, managers may use income smoothing to
reduce the likelihood of reporting low earnings, which minimizes the risk of managers being
fired. Another incentive for the use of income smoothing is potential debt covenants
violations. According to Scott (2014), the more volatile the stream of reported net income, the
14
higher the probability that covenant violation will occur (Scott, 2014). Consequently, in order
to have smooth covenant ratios over time, managers could smooth the reported earnings.
Finally, the management of companies may use income smoothing concerning external
purposes: by conveying its expected persistent earning power smoothing reported net income
can provide inside valuable information to the market (Scott, 2014).
Concerning the use of earnings management it is essential to underline one essential aspect
concerning these various accrual earnings management techniques: they can be in conflict
with each other. At a given point in time, a company can be confronted by conflicting
circumstances: to minimize income for political reasons, to maximize it to meet the analysts’
forecasts and the investors’ expectations, or to smooth income for borrowing purposes (Scott,
2014). In addition, a company may choose to engage in different techniques of earnings
management, depending on changes in the contracts, in the profitability and in the political
visibility (Scott, 2014).
2.2.3. Real Earnings Management
Managers can use real earnings management either as an alternative for the use of accruals
based earnings management or in combination with accrual earnings management.
Before pursuing with the presentation of real earnings management, a recall of the equation in
the previous section is required:
Total Earnings = Total Accruals + Net Cash Flows
While accrual earnings management involves manipulating accruals, in the case of real
earnings management net cash flows are manipulated (Li, McDowell, & Moore, 2008).
According to Xu et Al. (2007), earnings can be managed through manipulating various
operating, investing and financial activities (Xu, Taylor, & Dugan, 2007). Roychowdhury
(2006) defines real earnings management as “management actions that deviate from normal
business practices, undertaken with the primary objective of meeting certain earnings
thresholds” (Roychowdhury, 2006, p. 336). In addition, the last part of Schipper’s (1989)
definition of earnings management in general provides a definition of real earnings
management: “a minor extension of this definition would encompass ‘real’ earnings
management, accomplished by timing investment or financing decision to alter reported
earnings or some subset of it” (Schipper, 1989, p. 92).
15
Based on the definitions presented before can be concluded that real earnings management
relies on manipulating the real activities of the company. For instance, a reduction in the
discretionary expenses, e.g. R&D, which consequently increases the earnings, is considered as
a real earnings management practice (Cohen, Dey, & Lys, 2008).
Although real earnings management has not been studied as extensively as accrual earnings
management, Graham et Al. (2005) found that managers, in order to manage the reported
earnings, prefer to manipulate the real activities rather than manipulating the accruals
(Graham, Harvey, & Rajgopal, 2005). They found “strong evidence that managers take real
economic actions to keep up the accounting appearances. In particular, 80% of survey
participants report that they have investigated would decrease the discretionary spending on
R&D, advertising and maintenance to meet an earnings target. More than half (55.3%) of
survey participants state that they would delay starting a new project to meet an earnings
target, even when such a delay entails a small sacrifice in value” (Graham, Harvey, &
Rajgopal, 2005, p. 32).
Cohen and Zarowin (2010) provide two reasons for the managers’ inclination to use real
earnings management: first, accrual earnings management has a higher change of being
critically examined and discovered by auditors than the use of real earnings management
activities do, e.g. product pricing, production, expenditures on R&D or advertising; and
second, using accrual manipulating only is too risky (Cohen & Zarowin, 2010).
2.2.4. Incentives for the Use of Earnings Management
Although the definitions presented before are widely accepted, since they are based on
managerial intent, which is unobservable, the definitions are difficult to directly
operationalize using attributes of the reported accounting numbers. With regard to managers
reporting incentives, Healy and Wahlen (1999) state that researchers have examined many
different incentives for the use of earnings management, such as: capital market expectations
and valuation, e.g. meeting the expectations of financial analysts, contracting motivations, e.g.
lending contracts, management compensation contracts, and regulatory motivations, e.g.
industry regulations, anti-trust and other regulations (Healy & Whalen, 1999). Managers may
engage in earnings management to meet the analysts’ forecasts, the purpose being to avoid
potential reputation damage and a potential negative share price reaction in the market, which
would follow after the failure to meet the expectations of the investors. Another perspective
towards earnings management reveals another incentive: management’s intent to have a
16
smooth and growing earnings path over time. In addition, Dechow and Skinner (2000)
concluded two strong incentives in particular:
“Managers have strong incentives to ‘beat benchmarks’, implying that firms just beating
benchmarks are potentially more likely to be engaging in earnings management.
Managers of firms desiring to issue equity have strong incentives to boost the stock price
and hence engage in earnings management.” (Dechow & Skinner, 2000, p. 248)
2.2.5. What are the positions of the regulators and of the dependent bodies?
As Dechow and Skinner (2000) in their paper argue, accounting academics often perceive
earnings management differently from regulators and practitioners. On one hand, regulators
and practitioners generally qualified earnings management as to be pervasive, problematic
and they consider it needs remedial action. On the other hand, academics are hesitant when it
comes to believing that most firms actively engage in earnings management or whether
investors should really be concerned when earnings management actually exists (Dechow &
Skinner, 2000). They conclude that the reality is somewhere in the middle: academics seem to
be underrating the earnings management issue, whereas regulators and practitioners generally
overstate the extent of the problem regarding earnings management (Dechow & Skinner,
2000).
2.3. Agency Theory
Instituted by Jensen and Meckling (1976), the agency theory concerning this thesis has a high
relevance, addressing the management’s behaviour in a mandatory audit firm rotation
environment. The agency theory explains the relationship between the principals and the
agents in business and is concerned with resolving problems that arise in agency relationships,
i.e. between the principals, such as shareholders, and the agents of the principals, such as
company executives (Jensen & Meckling, 1976). The principal-agent problems arise when the
desires, goals and/or interests of the principal and the agent are in conflict, and the principal is
unable to verify what the agent is actually doing; this situation occurs due to the information
asymmetry, which arises when the agent has direct access to information, while the
information accessible to the principal is indirect and inferior. In a situation like this the agent
might engage in a behaviour that is beneficial for him, rather than for the principal. Other
problems arise when the principal and the agent have different attitudes towards risk: because
of these differences in their risk tolerance, the principal and the agent may have the tendency
17
to undertake different decisions and actions. Because the agent is supposed to act in the
benefit of the principal by managing the business so the principal’s goals and objectives are
met, these problems are essential in every business. .
However, this is not always the case. In order to put the interests of the agent back in line with
the interests of the principal, compensation schemes, such as bonuses or stock ownerships,
often are used (Shapiro, 2005).
2.4. Positive Accounting Theory
This thesis studies the behaviour of the management in terms of the use of earnings
management; consequently, in order to understand the management’s behaviour, it is essential
to have knowledge of the positive accounting theory, which is highly relevant to this thesis.
This theory has been introduced by Watts and Zimmerman (1978), who used the agency
theory presented in the previous paragraph as a fundamental object for the development of the
positive accounting theory (Watts & Zimmerman, 1978). The positive accounting theory is
concerned with predicting and explaining why managers choose to use specific accounting
policies and in which way managers respond to new accounting standards, by taking into
consideration several internal and external factors (Scott, 2014). Watts and Zimmerman
(1978) formulated factors that influence the management’s attitudes on accounting standards
and the management’s accounting choices. The factors they provide are: taxes, regulation,
management compensation plans, bookkeeping costs, and political costs.
This theory relies on the assumption that individuals are particularly driven by self-interest.
That implies that individuals will seek to maximize their own wealth by taking advantage of
their superiority in the information asymmetry issue. The manager takes several aspects into
consideration when deciding which accounting method to use. It is essential to emphasize
that, since it would be too costly, the positive accounting theory does not suggest that firms
and standard setters should completely specify the accounting policies they will use. It is
rather beneficial to allow managers a degree of flexibility to choose from a collection of
available policies so they will be able to adapt to unexpected circumstances. However, giving
managers the ability to choose from a set of accounting policies creates the prospect of
opportunistic behaviour “ex post” (Scott, 2014). That implies that managers might choose
from the set of accounting policies the one for their own interest. This underlines the
assumption of the positive accounting theory that managers, like investors, are rational and
would choose accounting policies for their own purpose if they are able to do so. Hence, the
18
positive accounting theory does not assume that managers will just act for maximizing the
firm’s profits, but the manager will maximize profits if he considers being in his own benefit.
The positive accounting theory’s predictions by Watts and Zimmerman (1986) are arranged in
three hypotheses.
The bonus plan hypothesis assumes that managers of firms with bonus plans are more likely
to choose accounting procedures that shift the reported earnings from the future periods to the
current period (Scott, 2014).
The debt covenant hypothesis postulates that the closer a firm is to the violation of the
accounting-based debt covenants, the more likely the firm manager is to select accounting
procedures that shift the reported earnings from the future periods to the current period (Scott,
2014).
Finally, the political cost hypothesis assumes that the greater the political costs of a firm, the
more likely managers are choose accounting methods that defer the reported earnings from
the current period to the future periods (Scott, 2014).
2.5. Legitimacy Theory
The fundament of the legitimacy theory is the “social contract” between the organisations and
the society. The legitimacy theory posits that organisations try to ensure that they operate
within the boundaries of the rules, norms and social values of the society, consequently the
society will perceive the organisation as legitimate (Deegan & Unerman, 2011). Organisations
agree to perform various socially appropriate actions in return for the approval of its
operations and objectives, or other benefits, such as legitimacy or other resources, which
ultimately guarantee its continuing existence. On the other hand, if an organisation does not
respect the social contract signalled before, the organisation will suffer consequences, such as
legal lawsuits or a decline in sales. The most well-known tool to ensure the legitimacy is the
corporate social responsibility (CSR) reporting; in which organisations disclose their
operations and the impact of their operations on the environment and on the society. The main
purpose for publishing CSR reports, which is purely voluntary, is to ensure that the
organisation is qualified as legitimate by the society.
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2.6. Summary
In this chapter, the background of the mandatory audit firm rotation and the use of earnings
management were presented, by commenting on theoretical frameworks that have an essential
relevance to this thesis. First, in paragraph 2.1, the evolution of the mandatory audit firm
rotation was presented: after the major financial reporting scandals, in the US in 2002 SOX
was implemented, which enforced the mandatory partner rotation, but audit firm rotation rule
was not mandated. However, in the European Union, Italy has an active MAFR rule, while in
the Netherlands MAFR will become active starting from 2016. In addition, the European
Commission recently has proposed a MAFR rule for all the Member States. In section 2.3, the
background and the definition of the use of earnings management have been provided, and the
content of the term “earnings management” is presented. Next, in paragraph 2.2, comments on
the theoretical framework of the term earnings management have been presented. In addition,
several incentives have been discussed that determine managers to engage in earnings
management. Concerning the management’s incentives to engage in earnings management,
agency theory is highly relevant, by addressing the principal-agent issue that arises in the
auditor-client relationship. Finally, sections 2.3, 2.4 and 2.5 present the broad theories that
this thesis relies upon, that is Agency Theory, the Positive Accounting Theory and the
Legitimacy Theory, respectively. References to these theories will be made in later chapters.
The next chapter presents models to measure the use of earnings management.
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3. Models for Detecting and Measuring the Use of Earnings
Management
The purpose of this chapter is to answer the third sub-question of this thesis:
“Which models in prior research are used concerning detecting and measuring the use of
earnings management?”
As signalled before, the focus of this thesis is on accruals-based earnings management.
Measuring accruals can be performed in two ways: the single accrual approach and the total
accrual approach. The total accrual approach in this thesis will be used.
Accordingly, the most relevant models for detecting and measuring the use of earnings
management used in prior scientific research will be presented. Finally, the reasoning for
selecting the model to be used when testing the hypotheses will be provided.
3.1. Jones Model
Jones (1991) developed the model for detecting and measuring the use of earnings
management through the use of discretionary accruals. She tested whether firms tend to
manage earnings downward during import relief investigations by the United States
International Trade Commission (ITC), and finds evidence to support the earnings
management hypothesis (Jones, 1991). To develop this model concerning investigating the of
earnings management, Jones based her work on measures used in prior scientific studies, i.e.
Healy (1985), DeAngelo (1986), and McNichols and Wilson (1988), which also used some
type of discretionary accruals measure. However, Jones’s study only builds on these measures
and uses the discretionary portion of the total accruals to detect and measure the use of
earnings management, rather than focusing on a single accrual account, as McNichols and
Wilson (1988) in their study did.
The first step of the Jones (1991) model is to calculate the total accruals, as follows:
TAit = ΔCAit – ΔCLit – ΔCASHit + ΔCPLTDit – DEPNit (1)
Where:
TAit = total accruals for firm i in year t;
ΔCAit = change in current assets for firm i in year t;
ΔCLit = change in current liabilities for firm i in year t;
21
ΔCASHit = change in cash and marketable securities for firm i in year t;
ΔCPLTDit = change in current portion of long-term debt for firm i in year t;
DEPNit = depreciation and amortization expense for firm i in year t;
The second step is to estimate the coefficients b0, b1 and b2 based on the next equation:
TAit/Ait-1 = b0 [1/Ait-1] + b1 [ΔREVit / Ait-1] + b2 [PPEit / Ait-1] + εit (2)
Where:
TAit = total accruals in year t for firm i;
ΔREVit = change in revenues, i.e. revenues in year t less revenues in year t-1 for firm i;
PPEit = gross property, plant and equipment in year t for firm i;
Ait-1 = total assets in year t-1 for firm i;
εit = error term in year t for firm i;
In this equation, total accruals, i.e. TA, includes changes in working capital accounts, e.g.
accounts receivable and accounts payable. To control for variability in the firm’s economic
environment changes, Jones includes revenues in the model, i.e. ΔREV (Jones, 1991).
The third step in the Jones (1991) model is to calculate the prediction error for estimating total
accruals by using the estimates of the b0, b1 and b2 coefficients computed in the previous step
as β0, β1 and β2:
µit = TAit/Ait-1 – [β0 (1/Ait-1) + β1 (ΔREVit/Ait-) + β2 (PPEit/Ait-1)] (3)
The estimated prediction error, i.e. µit, is the proxy for the discretionary accruals.
Consequently, the equations for calculating the non-discretionary accruals and the
discretionary accruals can be extrapolated:
NDAit = β0 [1/Ait-1] + β1 [ΔREVit/Ait-1] + β2 [PPEit/Ait-1] (4)
DAit = TAit – NDAit (5)
Where:
NDAit = non-discretionary accruals in year t for firm i;
DAit = discretionary accruals in year t for firm i;
22
3.2. Modified Jones Model
The original Jones model has provided a relevant understanding regarding the detection and
the measurement of the use of earnings management, many researchers using it in other
studies about the use of earnings management. However, over time, it became subject to
criticism. Consequently, other researchers have performed efforts to upgrade the original
model and make it more effective and accurate. To the original Jones model two types of
adjustments have been performed: data adjustment and variable adjustment.
The first type, i.e. data adjustment, addresses the data to be used in the model for estimating
accruals. The most significant data adjustment was performed by DeFond and Jiambalvo
(1994), who, to improve the original model that used time-series data, introduced the usage of
cross-sectional data.
The variable adjustment type of modification addresses the variables used in the model. The
modified Jones models attempt to improve the original model by adding extra variables, or by
substituting the original variables with items that have the potential to be more relevant.
Dechow et Al. (1995) introduced the modified Jones model, by adjusting the change in
revenues with the change in the account receivables. The purpose of this modification was to
eliminate the tendency of the original model to erroneously measure the discretionary accruals
when discretion was applied by managers over revenues.
NDAt = a1 (1/At-1) + a2 (∆REVt - ∆RECt) + a3 PPEt (6)
Where:
∆REVt = change in revenues, i.e. revenues in year t less revenues in year t-1, scaled by
total assets at t-1;
∆RECt = change in net receivables, i.e. net receivables in year t less net receivables in
year t-1, scaled by total assets at t-1;
PPEt = gross property, plant and equipment in year t, scaled by total assets at t-1;
At-1 = total assets at t-1;
a1, a2, a3 = firm-specific parameters;
This modified version of the Jones (1991) model assumes that the changes in the sales result
from the use of earnings management.
23
3.3. The Industry Model
The Industry Model was used by Dechow and Sloan (1991), and in addition was considered
by Dechow et Al. (1995). This model, just like the original Jones model, relaxes the premise
that the non-discretionary accruals would be constant over time. In addition, it assumes that
variations in the factors that affect the non-discretionary accruals are standard for firms in the
same industry. Consequently, the Industry Model is:
NDAt = γ1 + γ2 median(TAt) (7)
Where:
median(TAt) = the median value of total accruals scaled by lagged assets for all non-sample
firms in the same 2-digit SIC code;
γ1, γ2 = specific parameters estimated using OLS on the observations in the estimation
period;
Regarding the Industry Model, as Dechow et Al. (1995) presented one problem exists: “If
changes in non-discretionary accruals largely reflect responses to changes in firm-specific
circumstances, then the Industry Model will not extract all non-discretionary accruals from
the discretionary accrual proxy” (Dechow, Sweeney, & Sloan, 1995, p. 200).
3.4. The Healy Model
Introduced by Healy (1985), this model’s approach for detecting and measuring earnings
management is by comparing mean total accruals scaled by lagged total assets across the
earnings management partitioning variable. The Healy Model is:
NDAτ = ∑ TAt / T (8)
Where:
NDA = estimated nondiscretionary accruals;
TA = total accruals scaled by lagged total assets;
τ = a year subscript indicating a year in the event period;
3.5. The DeAngelo Model
This model was introduced by DeAngelo (1986), who tested the use of earnings management by assuming a special case of the Healy Model in which the estimation period is restricted only to the previous year. She used total accruals scaled by lagged total assets from the
24
previous period as a proxy for the non-discretionary accruals. Consequently, the DeAngelo Model is:
NDAτ = TAt-1 (9)
3.6. McNichols Model
McNichols (2002) model is another version of a modified Jones (1991) model. It is based on
Dechow and Dichev’s (2002) work by adding the cash flows from three periods, i.e. previous,
current and future, into the Jones model (McNichols, 2002). Consequently, the McNichols
Model is:
NDAt = a1(1/At-1) + a2CFOt-1 + a3CFOt + a4CFOt+1∆REVt + a5PPEt (10)
3.7. Forward Looking Model
The Forward Looking Model was developed by Dechow et Al. (2003), they studied whether
managing discretionary accruals upward to report small profits is a reasonable explanation for
why “too few firms report small losses, too many firms report small profits” (Dechow,
Richardson, & Tuna, 2003, p. 355). In order to perform the classification of the non-
discretionary and the discretionary accruals more effective, they adjusted the modified Jones
model, by performing three major modifications. First, the revenues variable is substituted by
a variable that in addition includes receivables. In addition, in the model two variables are
added to control for the changes in the economic environment. Consequently, the Forward
Looking Model is:
NDAt = a1(1/At-1) + a2[(1+k)∆REVt - ∆RECt] + a3PPEt + a4TAt-1 + a5Gr_Salest (11)
Where:
TAt-1 = total lagged accruals;
Gr_Salest = change in sales from current to next year scaled by current sales;
k = expected change in accounts receivable for a given change in sales, estimated
from the following equation:
∆RECt = a1 + k ∆REVt + εt (12)
3.8. Performance Matched Model
The Performance Matched Model by Kothari et Al. (2005) was developed, by addressing the
next problem of prior models concerning detecting and measuring the use of earnings
management: the inability to recognize the correlation between the firm’s performance and
25
the accruals. Consequently, these models have measuring errors when they test for the use of
earnings management on samples with firms which have high performances. It improves the
earnings management detection and the measurement of the modified Jones model by
including a performance component to control for extreme performance. Consequently, the
Performance Matched Model related to the modified Jones model is:
NDAt = α1 + α2(∆REVt - ∆RECt) + α3PPEt + a4ROAt or (t-1) (13)
Where:
ROAt or (t-1) = return on assets at t or t-1;
3.9. Which earnings management measurement models to test the hypotheses in
this thesis will be used?
At this point, eight relevant models concerning detecting and measuring the use of earnings
management have been presented. An assessment on these models and on their ability to
produce the best results concerning this thesis needs to be performed. First, according to
Dechow et al. (1995), the Jones (1991) and the modified version of the Jones (1991) model
are the best models for measuring the discretionary accruals and detecting the use of earnings
management, by comparing the ability to detect and to measure the use of earnings
management of the next models: The Healy (1985) Model, The DeAngelo (1986) model, The
Jones (1991) model, The Modified Jones Model and The Industry Model. Consequently, since
it is a more recent model, the Performance Matched Model by Kothari et Al. (2005),based on
the Modified Jones Model will be used to test the hypotheses in this thesis; this improves
earnings management detection and the measurement of the Jones model by including a
performance component to control for extreme performance. An additional reason why this
model in this thesis will be used relies on Beneish’s (1997) findings, in his paper he showed
evidence in that “extreme performance limits the usefulness of accrual models” (Beneish,
1997, p. 271).
3.10. Summary
In this chapter, eight models for detecting and measuring the use of earnings management
have been discussed. For the purpose of this thesis, it is essential to have a good
understanding of the relevant models used in prior research concerning the use of earnings
management, as well as the evolution and development of these models. First, since it has
provided essential insights in prior scientific studies, the original Jones (1991) model was
26
presented. Next, modified versions of the Jones model have been presented, as well as the
models that were used before the Jones model: the Healy model and the DeAngelo model.
The modified versions of the Jones model signalled in this chapter were developed by
researchers based on the original model, trying to improve its ability to differentiate between
discretionary and non-discretionary accruals. Finally, the Performance Matched Model by
Kothari et Al. (2005) related to the modified Jones model has been selected as the primary
tool that will be used in this thesis to test the hypotheses.
In the next chapter, the existing evidence from prior empirical studies that is relevant to this
thesis will be analysed.
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4. Evidence from Prior Research
This chapter answers the fourth sub-question of the thesis: “What does evidence from prior
research communicate so far about the effect MAFR has on the management’s behaviour in
terms of the use of earnings management?”
In order to answer this question, a literature review of the most relevant papers that contribute
to the understanding of the effect mandatory audit firm rotation has on the management’s
behaviour in terms of earnings management will be presented.
Because the only European country that has an active mandatory audit firm rotation rule
active is Italy, and in the US mandatory rotation is not mandated, the literature regarding
mandatory rotation is limited. Existing papers mostly focus on the auditor tenure, without
testing in an actual MAFR setting. However, some prior empirical papers have studied the
relationship between the use of MAFR and topics like auditor independence and audit quality.
A review of the papers that study these relationships is highly relevant to this thesis and
contributes to answering the main research question. Consequently, the background, the
methods they used and the findings of these papers will be commented.
Accordingly, this chapter is structured as follows: first, the study “Does Mandatory Audit
Firm Rotation Enhance Auditor Independence? Evidence from Spain” by Ruiz-Barbadillo et
Al. (2009), will be presented. Next, two research papers concerning the effect mandatory
audit firm rotation has on audit quality will be commented. Although this relationship, i.e.
between MAFR and audit quality, is not the subject of this thesis, these papers can provide
essential insights, especially in integration with another relevant paper: “The Effect of Audit
Quality on Earnings Management” by Becker et Al. (1998). Finally, papers that studied the
relationship between the audit tenure and the use of earnings management will be presented.
4.1. The relationship between MAFR and the auditor independence
“Does Mandatory Audit Firm Rotation Enhance Auditor Independence? Evidence from
Spain” by Ruiz-Barbadillo et Al. (2009)
This paper investigates the economic dependence effect in a mandatory audit firm rotation
setting. They test whether the propensity of issuing going-concern audit opinions would be
higher in the mandatory rotation period, i.e. before 1995 in Spain, than in the post-mandatory
rotation period, i.e. after 1995 (Ruiz-Barbadillo, Gomez-Aguilar, & Carrera, 2009).
28
Using the likelihood of issuing going-concern opinions in the audit report as a proxy for
auditor independence, Ruiz-Barbadillo et Al. (2009) tested their hypotheses in a sample of
1.326 Spanish companies which were in a financial distress situation during the period of
1991 – 2000. The relevance of this paper concerning this thesis is that Spain had an active
mandatory audit firm rotation rule from 1988 until 1995, when companies were required to
rotate their auditors every nine years. Based on the fact that the rule was cancelled after seven
years, the rotation was never enforced. However, during this period in Spain a real MAFR
setting exists, which should reflect in the auditors’ behaviour. In order to assess the effect of
the mandatory rotation on the auditors’ behaviour, Ruiz-Barbadillo et Al. (2009) have divided
the sample in two periods: a mandatory rotation period, i.e. 1991-1994, and a post-mandatory
rotation period, i.e. 1995-2000.
Their findings suggest that no significant evidence exists to support their hypotheses. That is,
no eloquent evidence for the association between the economic dependence and the
probability of issuing a going-concern audit report in either the settings used in the testing:
mandatory or non-mandatory rotation periods (Ruiz-Barbadillo, Gomez-Aguilar, & Carrera,
2009). On the other hand, they found evidence for a strong positive effect that auditors’
incentives to maintain their reputation have on the probability of issuing going-concern
opinions in the post-mandatory rotation period (Ruiz-Barbadillo, Gomez-Aguilar, & Carrera,
2009). However, some limitations in this study exist, concerning the measures used to test the
hypothesis and the Spanish particular setting.
To conclude, the findings of Ruiz-Barbadillo et Al. (2009) support, to a certain extent, the
claims of the opponents of the mandatory audit firm rotation as a measure for improving the
auditors’ independence.
4.2. The relationship between MAFR and the use of earnings management analysed in
two steps: (1) the effect of MAFR on the audit quality and (2) the effect of the
audit quality on the use of earnings management
In this section, three papers will be used to reach a preliminary conclusion regarding some
aspects of the relationship between MAFR and the use of earnings management. In the first
step, two papers which studied the effect of MAFR on the audit quality will be presented: one
testing a sample from Australia, a non-MAFR setting, and one testing a sample from Italy, a
real MAFR setting. In the second step, the paper of Becker et Al. (1998), who studied the
relationship between the audit quality and the use of earnings management, will be presented.
29
4.2.1. The effect of MAFR on the audit quality
“Mandatory Audit Firm Rotation and Audit Quality” by Jackson et Al. (2008)
Jackson et Al. (2008) in their paper tested whether the rotation of audit firms has an effect on
audit quality. (Jackson, Moldrich, & Roebuck, 2008)
This research tests the hypothesis concerning a sample of Australian listed companies.
Considering the fact that no mandatory audit firm rotation rule has ever been enforced in
Australia, Jackson et Al. (2008) investigate the financial elements of the companies in the
years before, and after the change of the auditor. Concerning this purpose, they analyse
switches of audit firms in the period of 1995-2003. By the researchers both types of auditor
switches are taken into consideration: voluntary audit switches, and audit firms switched by
the client.
In addition, Jackson et Al. (2008) provide reasons why companies choose to switch their
auditors in a non-mandatory rotation setting. One reason is to keep the auditors away from
issuing qualified audit reports. They argue that managers do not tolerate qualified audit
reports because such a report could convey to the shareholders that managers’ actions may not
be in accordance with the shareholders’ goals and interests; moreover, since their
compensation is dependent on the company’s share price on the market and the share price
drops with a qualified audit report the managers’ income would be indirectly affected by a
qualified audit report t (Jackson, Moldrich, & Roebuck, 2008).
The findings of Jackson et Al. (2008) suggest that, if implemented, the usefulness of the
mandatory audit firm rotation for improving the audit quality would be minimal. In fact, they
indicate a positive association between the audit tenure and the audit quality, when the
propensity of issuing going-concern opinions in the audit reports is used as a proxy for the
audit quality. Consequently, this paper supports the opponents of the mandatory audit firm
rotation. However, in this study certain limitations arise. First, this paper only addresses the
actual audit quality, without considering the perceived audit quality, which could be improved
by a mandatory rotation rule. Jackson et Al. consider the perceived audit quality as “an
important component to the efficient operations of financial markets” (Jackson, Moldrich, &
Roebuck, 2008, p. 434).
30
“Mandatory Audit Firm Rotation and Audit Quality: Evidence from the Italian Setting” by
Cameran et Al. (2012)
Since it investigates the change in the audit quality during the allowed audit engagement
period in the Italian MAFR setting, this paper is of high importance concerning this thesis.
Concerning the behaviour of auditors, a real mandatory rotation setting is more relevant than a
non-mandatory rotation setting, in which a switch of the auditor is voluntary.
Cameran et Al. (2012) test whether audit quality is higher in the last engagement period prior
to the rotation. They test the hypothesis on a sample of 171 Italian companies listed on the
Milan Stock exchange in the period 1985-2004.
In order to test the hypothesis, they used an accrual-based approach for measuring audit
quality. The proxy for the audit quality used in this study is represented by the abnormal
working capital accruals.
Their findings confirm the results of the previously signalled research paper, i.e. Jackson et
Al. (2008), by showing evidence that audit quality has the tendency to increase in the final
period of the engagement, i.e. before the mandatory rotation. In addition, they investigated the
effect of the mandatory audit firm rotation on the perceived audit quality. They found
significant evidence that the perceived audit quality follows the trend of the actual audit
quality and has the tendency to increase in the final period of the engagement, i.e. before the
mandatory rotation (Cameran, Prencipe, & Trombetta, 2012). Concerning his test, Cameran et
Al. (2012) used the earnings response coefficient (ERC) as a proxy for the perceived audit
quality.
Based on the two articles presented before, i.e. Jackson et Al. (2008) and Cameran et Al.
(2012), the finding is: no evidence exists to support the claim that the audit quality will
increase when the auditor is required to be rotated. Consequently the argument of the
advocates of the mandatory audit firm rotation regarding the audit quality is contradicted.
4.2.2. The effect of auditors’ behaviour on the use of earnings management
“The Effect of Audit Quality on Earnings Management” by Becker et Al. (1998)
This research paper investigates the relationship between the audit quality and the use of
earnings management. Since it measures the use of earnings management through the use of
discretionary accruals, which are determined from a cross-sectional version of the Jones
31
(1991) model, this study has an important relevance towards this thesis. . Moreover, together
with the previous papers on the audit quality, it provides essential insights regarding the
answer to the main research question of this thesis.
In addition, this paper analyses one external factor, i.e. the quality of the auditor, which
restricts the use of earnings management, unlike many other research papers that focus more
on the incentives of the managers to engage in earnings management.
They use a dummy variable as a proxy for audit quality, considering Big Six auditors as
higher quality auditors than non-Big Six auditors. As for detecting and measuring the use of
earnings management, Becker et Al. (1998) use a modified version of the Jones model.
In order to test the hypothesis, Becker et Al. (1998) use a sample of more than 10.000 non-
financial firm year observations, collecting the data from the Compustat database for a period
of four years: 1989-1992.
The findings of Becker et Al. (1998) suggest a significant negative association between the
audit quality and the use of earnings management. In other words, they found evidence to
support the claim that non-Big Six auditors’ clients report a significantly higher amount of
discretionary accruals, compared with Big Six auditors’ clients (Becker, Defond, Jiambalvo,
& Subramanyam, 1998). Assuming that audit quality improves when a mandatory audit firm
rotation rule is in place, this paper supports the claims of the advocates of the mandatory audit
firm rotation.
Based on the evidence before it is essential to have a proper understanding of the insights
provided by the three papers signalled in subchapter 4.2. To summarize, the first two papers,
i.e. Jackson et Al. (2008) and Cameran et Al. (2012), found no evidence concerning a positive
association between the mandatory audit firm rotation and the quality of the audit. However,
the results of the paper by Jackson et Al. (1998) suggest that the higher the audit quality, the
lower the magnitude of the use of earnings management. It is rather difficult only based on
these papers to assess the relationship between the mandatory audit firm rotation and the
management’s behaviour in terms of the use of earnings management. Consequently, the next
section will provide insights from additional papers related to the audit tenure, which is
considered of high relevance concerning this thesis.
32
4.3. The relationship between the audit tenure and the use of earnings management
“Auditor Tenure, Auditor Independence and Earnings Management” by Davis et Al.
(2000)
Since it investigates the relationship between the auditor tenure and the magnitude of the use
of earnings management, and provides essential insights for this thesis, the paper by Davis et
Al. (2000) is one of the most relevant prior researches concerning this thesis.
In this paper, this relationship is tested using two approaches: towards absolute values, and
towards signed values. In addition, they measure earnings management in two ways:
discretionary accruals and the forecast error. (Davis, Soo, & Trompeter, 2000)
The hypotheses related to the discretionary accruals are tested with a sample of 855 non-
financial firms in the period of 1981-1998 selected in Compustat. In order to properly
measure the tenure of the auditors, this sample is divided in two sub-samples: one sub-sample
with 589 firms that did not change their auditors over the observed period and another one
with 266 firms that changed their auditors at least once during the period. Concerning the
hypotheses related to the forecast error, data was collected from I/B/E/S. However, data
regarding the analysts’ forecasts only for 637 firms were available: 476 from the first sub-
sample, and 161 in the second sub-sample.
As a proxy for the use of earnings management, estimated with a modified version of the
Jones model, discretionary accruals were used. Concerning the analysts’ forecasts, a model is
used to estimate the forecast error, by considering the forecast horizon, i.e. the number of
months between fiscal year-end and the most recent forecast, the number of analysts making
the earnings forecasts, and the forecast dispersion.
The findings of Davis et Al. (2000) indicate a significant positive correlation between the
audit tenure and the amount of absolute discretionary accruals, as well as a significant
negative correlation between the audit tenure and the absolute forecast errors. On the other
hand, concerning the signed discretionary accruals and the signed forecast errors, a significant
negative association is found regarding the accruals and a significant positive association is
found regarding the forecast errors. In other words, these findings support the claim that
managers take advantage of the flexibility to decrease the published earnings. In addition,
these results vary throughout the sub-samples. Concerning the sub-sample with at least one
change of the auditor, evidence is less significant.
33
In conclusion, the findings of Davis et Al. (2000) support, to a certain extent, the claims of the
advocates of the mandatory audit firm rotation as a measure for improving the auditors’
independence.
“Exploring the Term of the Auditor-Client Relationship and the Quality of Earnings: A
Case for Mandatory Auditor Rotation?” by Myers et Al. (2003)
Being motivated by the debate that surrounded the case for the mandatory audit firm rotation,
the study of Myers et Al. (2003) is highly relevant concerning this thesis. Moreover, they
investigate the relationship between the tenure of the auditors and the quality of published
earnings, based on the assumption that the higher the auditor tenure, the lower the quality of
earnings, by using accruals as a proxy for the earnings quality.
The hypotheses are tested in a sample of 42.302 firm year observations from the period of
1988 to 2000, since estimating accruals for these firms can be rather complicated excluding
the firms which were involved in mergers and in acquisitions (Collins & Hribar, 2002).
Concerning the proxy used for measuring the earnings quality, i.e. accruals, two measures are
used: current accruals and discretionary accruals.
The findings of this paper suggest a significant negative association between the auditor
tenure and the dispersion of the current and the discretionary accruals (Myers, Myers, &
Omer, 2003). In other words, they found that auditors tend to exercise a stronger constraint
over the manipulation of accruals by the management when the auditor tenure is longer.
Myers et Al. (2003) based on their tests provide evidence to support the claim of the
opponents of mandatory audit firm rotation, concluding that the mandatory audit firm rotation
may not be the best option to address the audit quality and the earnings quality issues. Their
results suggest that a longer auditor-client relationship does not reduce the audit quality, or the
earnings quality. However, concerning this study certain limitations exist. First, the
researchers do not address all the aspects of the use of earnings management. In addition, the
tests used in this paper do not consider the incentives of the managers to engage in earnings
management.
34
“Audit Partner Tenure, Audit Firm Tenure, and Discretionary Accruals: Does Long
Auditor Tenure Impair Earnings Quality?” by Chen et Al. (2008)
Chen et Al. (2008) in this paper investigated the relationship between the audit firm tenure
and the quality of the published earnings, as well as the relationship between the audit partner
tenure and the quality of the published earnings. Studies on the second relation have not been
performed as extensively as concerning the first one, consequently this paper can provide
valuable insights for the purpose of this thesis, by controlling for the partner tenure when
testing for audit firm tenure. This adds value to the results of this study and makes them more
relevant for this thesis.
Chen et Al. (2008) test the hypotheses with a sample of 888 non-financial companies from the
Taiwan Economic Journal (TEJ) database, with a total of 5.213 observations, excluding the
companies from small industries.
To measure the earnings quality, estimating them with a modified version of the Jones model,
discretionary accruals are used. The cross-sectional modified Jones model used by Dechow et
Al. (1995) by Chen et Al. (2008) is adjusted, by adding a control variable for the prior
performance of the company.
The findings suggest a significant negative correlation between the audit partner tenure and
the level of the discretionary accruals. According to the results of Chen et Al. (2008) the
longer the partner tenure, the higher the earnings quality is. This correlation is even stronger
when considering the use of earnings management with the income increasing purposes. After
controlling for audit partner tenure the relationship between the audit firm tenure and the
quality of the published earnings, the correlation is significantly negative as well (Chen, Lin,
& Lin, 2008).
The results of this paper contradict the claim of the advocates of the mandatory rotation: both
for partners and for audit firms. However, since the Taiwanese environment experiences
specific characteristics, the results of this study are difficult to generalize to the rest of the
population, especially to companies in Europe.
35
4.4. Comparative Assessment of the Prior Literature
The evidence from the papers presented before in this chapter is comparatively presented in
this section.
First, Ruiz-Barbadillo et Al. (2009) concluded that no significant evidence exist to support the
statement that the probability of issuing going-concern audit opinions would increase in either
of the settings they used. These findings claim that mandatory audit firm rotation does not
improve the independence of the auditor. On the other hand, Davis et Al. (2000) provide
empirical evidence that audit tenure has a significant negative effect on the independence of
the auditor. Davis’s et Al. (2000) findings are in line with the SEC regarding the impairment
of the auditor independence when audit tenure is longer. They also find evidence that this
empowers the management with more flexibility to engage in earnings management at a
higher degree, supporting the claim of the advocates of mandatory audit firm rotation. This
difference in their results creates tension in the literature. Possible explanations for the
differences in the results of Ruiz-Barbadillo et Al. (2009) and Davis et Al. (2000) can rely on
the difference of the settings of the tested sample, and the measures they use: the propensity
of issuing going-concern audit opinions vs. the amount of discretionary accruals. In
contradiction with the results of Davis et Al. (2000), Myers et Al. (2003) found evidence that
auditors tend to constrain more for the manipulation of accruals by the management when
auditor tenure is longer. That is, the longer the audit tenure, the lower the magnitude of the
use of earnings management, according to Myers et Al. (2003). Both papers, Davis et Al.
(2000) and Myers et Al. (2003), use discretionary accruals as proxies. This adds to the tension
of this thesis’s subject. In addition, the results of Myers et Al. (2003) are supported by the
paper of Chen et Al. (2008), who found evidence for a significant negative effect that audit
tenure has on the amount of discretionary accruals. Chen et Al. (2008) also control for audit
partner tenure in their tests. However, the findings of Chen et Al (2008) have limited
relevance because of the particularities of the Taiwanese environment, which was used for the
empirical tests. Another relevant paper for this thesis is the research conducted by Becker et
Al. (1998) on a sample of US firms. Their findings are in line with the arguments of the
advocates of the mandatory audit firm rotation, by providing evidence that high audit quality
constrains the management to manage earnings. That is, the higher the audit quality, measured
through a dummy variable regarding BigSix and non-BigSix auditors, the lower the amount of
discretionary accruals. However, the findings of Jackson et Al. (2008) limits the relevance of
Becker’s et Al. (1998) results regarding the mandatory audit firm rotation, by providing
36
evidence that the rotation of auditors does not improve audit quality. They reach this
conclusion by investigating the financials of Australian companies in the years before and
after changes of auditors. Considering the fact that the auditor switches in the Australian
setting are voluntary and no mandatory audit firm rotation is in place in this country, issues
arise when generalising these results to a MAFR setting. For this issue, the paper of Cameran
et Al. (2012) answers the question by testing this relationship in a real mandatory audit firm
rotation, i.e. Italy. Their results are consistent with the results of Jackson et Al. (2008),
providing evidence that audit quality increases in the final period of the auditor’s engagement,
before the mandatory rotation. They also provide valuable insights regarding the effect on the
perceived audit quality, showing that it follows the same trend as the actual audit quality.
In conclusion, two of the seven papers presented in this chapter support the claim of the
advocates of mandatory audit firm rotation and five papers are in line with the MAFR
opponents’ arguments.
4.5. Summary
In this chapter several scientific empirical studies have been presented.
The article of Ruiz-Barbadillo et Al. (2009) studied the relationship between the mandatory
audit firm rotation and the independence of the auditor. They found no evidence that MAFR
improves the auditors’ independence. In addition, the papers presented in section 4.2 suggest
that the implementation of MAFR would most likely not improve the audit quality. Finally,
the papers regarding audit tenure in section 4.3 have provided insights concerning the auditor-
client relationship and its effects.
It is essential to signal that most of the papers considered relevant for this thesis provide
empirical support for the opponents of the implementation of mandatory audit firm rotation.
Finally, a comparative assessment of the evidence from prior scientific research has been
presented in section 4.4 of this chapter. This assessment represents the basis for the
development of the hypotheses that will be presented in next chapter.
37
5. Hypotheses
This chapter provides the answer to the fifth sub-question of this thesis: “Based on the
research question and prior literature, in order to answer the research question which
hypotheses will be formulated?”
In the fourth chapter, the empirical literature relevant to this thesis was presented. Considering
this literature, it is essential to signal that some of the commented topics to this thesis are
relevant, but they will not be further investigated. The relationship between the auditor tenure
and the quality of the audit, as well as the relationship between the mandatory audit firm
rotation and the quality of audit, in the scientific prior literature are already extensively
investigated. However, even though they will not be further explored, they provide relevant
insights, which facilitate the formulation of the hypotheses of this thesis.
In this chapter, the correspondence between the scientific literature presented in chapter four
and the predictions of this thesis is presented. Finally, the predictions are shaped into two
hypotheses.
5.1. Hypotheses Development
This thesis investigates the behaviour of the management, in terms of the use of earnings
management, during the auditor-client relationship in a mandatory audit firm rotation setting.
One of the responsibilities of the management is to prepare the financial statements of the
company in accordance with the Generally Accepted Accounting Principles (GAAP) and
other applicable accounting standards. This process of the financial reporting requires
complex judgment and estimates, which provides managers with the opportunity to
manipulate the published figures. This situation is consistent with the agency theory,
especially considering the information asymmetry between what managers know about the
insides of the organisation, compared to the external stakeholders. This opportunity signalled
before generates the likelihood of the use of earnings management. In addition, Kothari
(2001) shows that news concerning positive abnormal returns creates a positive reaction in the
market (Kothari, Capital Market Research in Accountin, 2001), which in coexistence with the
management contracts that assume compensation based on the stock price, represents a
powerful motive for the use of earnings management.
38
While managers seem to have incentives to report a better performance of the company than
the reality, by managing earnings upwards, the external auditor is expected to be independent
and reduce the information asymmetry through the audited financial statements. Audited
financial statements are considered a relevant source of information which adds to the
decision-making process of the shareholders, investors and other stakeholders. However, after
the financial reporting scandals in the USA, in Italy and in the Netherlands, a significant
decrease in the public’s confidence in the reporting and the auditing process has occurred.
Mandatory audit firm rotation has been proposed as a measure for this situation, and
consequently the Dutch Parliament decided to enforce a MAFR law starting from 1st of
January 2016. A significant amount of research has been conducted on the effect of the
mandatory audit firm rotation on the behaviour of the auditor since then: Ruiz-Barbadillo et
Al. (2009), Jackson et Al. (2008), Cameran et Al. (2012), etc. Most of the papers on this topic
conclude against the advocates of mandatory audit firm rotation and consider that only
minimal benefits arise from the implementation of a MAFR rule in addressing the issues of
the auditors’ independence and of the audit quality. In addition, Butler et Al. (2004)
investigated whether managers engage less in earnings management activities when the
financial statements are audited by a high-reputation auditor. In addition they examine
whether the level of discretionary accruals is lower when the auditor’s opinion is other than
unqualified, i.e. qualified, adverse or disclaimer. They find no significant evidence for this
association (Butler, Leone, & Willenborg, 2004). These findings are contradicted by Becker
et Al. (1998), who found a significant negative association between the audit quality and the
use of earnings management.
Considering that the behaviour of auditors affects the behaviour of the management, it is
expected that the mandatory audit firm rotation itself has an effect on the management’s
behaviour.
The most relevant study for the development of this thesis’s predictions is the one by Davis et
Al. (2000). They found evidence that auditors with a longer tenure are more likely to presents
client management more flexibility in recording accruals to manage the published earnings.
Their findings represent the key foundation of why the prediction of this thesis is for the
magnitude of the use of earnings management increase with the auditor tenure, and drop in
the first year after the rotation. This prediction creates the formulation of the next two
hypotheses:
39
H1
The magnitude of the use of earnings management increases gradually as the auditor tenure
increases, positive correlation.
This hypothesis is based on the assumption that long-standing auditors become too familiar
with the client and allows the client’s management to engage more in earnings management.
Although, in prior research to support the claim that the audit quality decreases when the
tenure is longer, most of these studies have been conducted in non-mandatory firm rotation
environment, no significant evidence has been found. Considering that in this thesis the
hypotheses will be tested in a real MAFR setting, i.e. Italy, the prediction is that the amount of
discretionary accruals increases during the auditor retention period.
H2
The magnitude of the use of earnings management drops in the first year when a new auditor
is appointed.
The second hypothesis is based on the assumption that despite the increased costs, a new
auditor would be more determined to perform a quality audit than the predecessor in the last
years of the engagement, and the management would be more constrained in their flexibility
to manage the published earnings.
5.2. Summary
This chapter presented the connection between the most relevant papers from prior scientific
literature and the formulation of the hypotheses has been presented. This thesis tests two
hypotheses. Hypothesis 1 examines the management’s behaviour during the retention period
that is from the moment when a new auditor is appointed until the moment when the auditor is
rotated. The prediction of this thesis is that the magnitude of the use of earnings management
increases during this period. On the other hand, hypothesis 2 investigates what happens with
the earnings management trend in the first year after the rotation, compared to the last years of
engagement with the previous auditor. The expectation is to identify a significant decrease in
the amount of discretionary accruals, due to the presumed higher audit quality provided by the
new auditor, as claimed by the advocates of the mandatory audit firm rotation.
The hypotheses signalled in this chapter will be tested using the research design detailed in
the next chapter.
40
6. Research Design
This chapter provides the answer to the sixth sub-question of this thesis: “Which research
design will be used to test the formulated hypotheses and to answer the research question?”
and describes the research design to be used for testing the hypotheses. First, the research
approach to be used in this thesis will be chosen, after presenting the available types of
research. Next, the research method and the model for detecting and measuring the use of
earnings management will be presented. The focus of this chapter is on the statistical methods
used for conducting the empirical research. Next, the control variables and the methods that
will be performed for testing the hypotheses are presented. Finally, the sample characteristics
and the sources for collecting the data will be displayed.
6.1. Research approach
Empirical research is based on obtaining information through direct or indirect observations.
In the accounting scientific field, empirical research implies identifying interesting, relevant
and important topics in financial reporting, formulating a clear research question, developing
one or more hypotheses to answer the research question, and empirically testing these
hypotheses using a valid research design to obtain the empirical evidence for assessing the
answer to the research question. This empirical evidence can be assessed either quantitatively
or qualitatively. In certain situations, in the research process both approaches can be used.
However, this is not the case in this thesis. Consequently, before proceeding to the research
methodology, one of these two approaches in this thesis needs to be selected. The distinction
between the quantitative research and the qualitative research in the next paragraphs of this
section will be presented.
Quantitative research is more neutral and objective and implies collecting numerical data;
consequently, the relationship can be investigated in an unbiased way using certain statistical
methods. The results of a quantitative research consist of a series of numbers, which are
statistically analysed by the researcher. This approach generally applies for hard sciences
aiming to answer specific research questions through the hypotheses testing.
On the other hand, qualitative research is more subjective and implies a certain level of bias
from the researcher. Unlike the quantitative research, in which the researcher generally knows
specifically what the study aims for, qualitative research applies to situations when it is not
clear from the beginning what the study aims for exactly. In addition, qualitative research
41
involves collecting descriptive data, which requires the researcher to interpret the gathered
information, usually without using statistical methods. In order to provide valuable
information, qualitative research requires remarkable knowledge and training from the
researcher, consequently he/she can accurately interpret the collected information. However,
qualitative research usually is more expensive and time-consuming.
Considering the fact that this thesis aims to answer the research question by determining the
strength of the relationship between the independent variable, i.e. the length of the audit
tenure, and the dependent variable, i.e. the amount of discretionary accruals, in this thesis
quantitative research will be performed.
Five types of research exist: surveys, experiments, case studies, theoretical based studies and
desk research. Specifically, since this thesis uses existing material in combination with
reflection and no direct contact exists with the research object, concerning answering the
research question in this thesis a desk research will be conducted.
6.2. Research Methodology
In order to answer the main research question, in this thesis a quantitative research, using a
desk research approach, will be conducted. The approach of the empirical research is to
measure the magnitude of the use of earnings management through the amount of the
discretionary accruals.
6.2.1. Measuring the Amount of Discretionary Accruals (the dependent variable)
As it was signalled before in chapter 3 of this thesis, to measure the magnitude of the use of
earnings management the performance matched model of Kothari et Al. (2005) will be used.
This model is based on the modified Jones (1991) model, with an approach towards the
amount of the discretionary accruals, which represents the proxy for the use of earnings
management.
In measuring the discretionary accruals, this model assumes three steps. First, the amount of
the total accruals is computed, using the next equation:
TAit = ΔCAit – ΔCLit – ΔCASHit + ΔCPLTDit – DEPNit
42
Where:
TAit = total accruals for firm i in year t;ΔCAit = change in current assets for firm i in year t;ΔCLit = change in current liabilities for firm i in year t;ΔCASHit = change in cash and marketable securities for firm i in year t;ΔCPLTDit = change in current portion of long-term debt for firm i in year t;DEPNit = depreciation and amortization expense for firm i in year t;
The second step is to estimate the coefficients b0, b1, b2 and b3 based on the next equation:
TAit/Ait-1 = b0 [1/Ait-1] + b1 [ΔREVit / Ait-1 – ΔRECit / Ait-1] + b2 [PPEit / Ait-1] +b3 ROAit-1 + εit
Where:
TAit = total accruals in year t for firm i;ΔREVit = change in revenues, i.e. revenues in year t less revenues in year t-1 for firm i;ΔRECit = change in receivables, i.e. receivables in year t less receivables in year t-1 for
firm i;PPEit = gross property, plant and equipment in year t for firm i;Ait-1 = total assets in year t-1 for firm i;ROAit-1 = return on assets in year t-1 for firm i, computed as the net income/ total assets
ratio;εit = error term in year t for firm i;
Next, the non-discretionary accruals can be computed using the next formula:
NDAit = β0 [1/Ait-1] + β1 [ΔREVit/Ait-1 – ΔRECit / Ait-1] + β2 [PPEit/Ait-1] + β3 [ROAit-1/Ait-1]
Finally, the discretionary accruals are computed using the following equation:
DAit = TAit – NDAit
Where:
DAit = discretionary accruals in year t for firm i;NDAit = non-discretionary accruals in year t for firm i;TAit = total accruals in year t for firm i;
Once the measure for discretionary accruals is estimated, the hypotheses can be tested. The
model used for testing the hypotheses will be presented in section 6.2.4 of this chapter.
6.2.2. Measuring the length of the audit tenure (the independent variable)
Audit tenure is measured as the length of the auditor-client relationship. In order to compute
the audit tenure, the auditors of the firms in each year of the sample period are identified.
Next, the audit tenure is computed starting with 1 in the first firm-year observation, and
incrementing it for each year until the rotation.
43
ATit = the length, in years, of the auditor-client relationship as counted from the moment the
auditor was hired for firm i in year t.
6.2.3. Control variables
In order to investigate the effect mandatory audit firm rotation has on the management’s
behaviour in terms of earnings management, a regression model will be used. As signalled
before, it is clear that managers have certain incentives to engage in earnings management.
Since this might influence the magnitude of the use of earnings management, in the regression
model certain factors need to be considered. Consequently, the next control variables in the
model are included:
Firm size
A significant amount of studies concerning the use of earnings management have indicated
that controlling for the firm size is essential. Large profitable firms tend to engage in earnings
management by manipulating the accruals downwards. In other words, larger firms report
lower levels of discretionary accruals than smaller firms do. In this thesis, the control for firm
size is implemented through the variable SIZE, which is computed as the natural logarithm of
the total sales in year t.
Sales growth
In addition, sales growth is another factor that relates to the use of earnings management.
Several other empirical studies suggest that accruals are correlated with a company’s growth
opportunities. Consequently, sales growth as a control variable in the model is included. The
variable GROWTH is computed as the sales in year t minus the sales in year t-1, scaled by
sales in year t-1.
Leverage
A high leverage ratio can be an indicator of a high risk of bankruptcy. Because the threat of
debt covenant violations can create the incentive for management to increase the published
earnings by manipulating the discretionary accruals upwards, firms which experience high
leverage may have the tendency to engage more in the use of earnings management.
Consequently, the control for this effect in the regression model is included. The control
variable LEVERAGE is computed as the ratio of total liabilities to total assets in year t.
44
Prior loss
The situation of a loss in the prior year can be an indicator for financial distress. When a firm
reports a loss in the prior year, management may have the incentive to engage more in the use
of earnings management, increasing the published earnings in the following year by
manipulating the discretionary accruals upwards. To control for this effect, the dummy
variable PRIOR_LOSS in the regression model is included, which takes the value 1 if the firm
has reported a loss in year t-1, and the value 0 otherwise.
The control variables presented before are included in the next regression model, which will
be used for testing hypothesis 1.
DAit/Ait-1 = β0 + β1ATit + β2SIZEit + β3GROWTHit + β4LEVERAGEit + β5PRIOR_LOSSit + εit
6.2.4. Testing the hypotheses
In order to test the relationship between the auditor tenure and the magnitude of the use of
earnings management the next regression model will be used:
DAit/Ait-1 = β0 + β1ATit + β2SIZEit + β3GROWTHit + β4LEVERAGEit + β5PRIOR_LOSSit + εit
Where:
SIZEit = control variable, representing the firm size for firm i in year t, computed as natural logarithm of total sales;
GROWTHit = control variable, representing the sales growth for firm i in year t, computed as (Salest – Salest-1)/Salest-1;
LEVERAGEit = control variable, representing the leverage for firm i in year t, computed as (Total Liabilitiest/Total Assetst) ratio;
PRIOR_LOSSit = control dummy variable, taking the value 1 if the firm i has reported a loss in year t-1, 0 otherwise;
εit = error term;
Concerning answering the first part of the research question, the results of the regression
before will be analysed. In order to assess whether the H1 hypothesis is confirmed or rejected,
the β1 coefficient will be observed. To confirm the H1 hypothesis, the expectation is that β1 is
positive and statistically significant.
In order to assess whether the H2 hypothesis is confirmed or rejected, the distribution of the
discretionary accruals will be analysed, by comparing the amount of discretionary accruals in
the years where ATit = 1, with the amount of the discretionary accruals in the preceding year.
45
1
2
4
3
5
6.3. Validity framework
The concepts analysed in this thesis, i.e. audit quality in a mandatory rotation setting and the
magnitude of the use of earnings management, and are not directly observable. Consequently,
in order to measure these concepts, they need to be operationalized. Libby (1981) provides a
tool to operationalize unobservable concepts: the predictive validity framework (Libby,
1981).
In the Figure 1 below, the Libby boxes concerning the predictive validity framework are
presented.
Independent variable Dependent variable Control variables
Conceptual
Operational
Figure 1 – The Predictive Validity Framework: Libby’s (1981) boxes
This thesis studies the management’s behaviour in terms of the use of earnings management
in a mandatory audit firm rotation setting. In other words, it studies the correlation between
the audit quality in a MAFR setting and the magnitude of the use of earnings management
employed by management. In order to investigate this relationship, the use of earnings
management is employed as the dependent variable, measured through the amount of
discretionary accruals, while the independent variable is represented by the audit quality in a
MAFR setting, measured by the audit tenure, i.e. the length of the auditor-client relationship.
Firm size, sales growth, leverage and the existence of a loss in the prior year are included as
control variables.
The two Libby boxes from the conceptual level, i.e. audit quality in a MAFR setting and
earnings management, reflect the theoretical sector, while the boxes audit tenure and
discretionary accruals from the operational level reflect the empirical sector. The last box
46
Audit quality in a MAFR setting
Audit tenure
Earnings management
Discretionary accruals
Firm sizeSales growth
LeveragePrior loss
reflects the effect other factors have on the dependent variable, implemented as control
variables.
One of the most important parts of a research design is ensuring the validity. The validity of a
research reflects how effectively the research actually answers the research question. Existing
scientific theory provides three generally accepted validity features of empirical research,
which are presented in the next paragraphs of this section.
Internal validity
Internal validity reflects the extent to which the dependent variable is the result of the effect
from the independent variable. In Figure 1 presented before, the internal validity can be
visually identified through arrow 4.
As it was signalled before in this chapter, this thesis follows a desk research approach.
Because the numerical data used for estimating the discretionary accruals is collected from
various external sources, i.e. Compustat Global database, Orbis database, Thomson Research
database, Thomson One Banker database, as presented in section 6.4.2 of this chapter, the
accuracy and the reliability of the data is in question. Consequently, this implies that this
thesis has a relatively low internal validity. However, the implementation of control variables
addresses this issue and should increase the internal validity of this thesis. In addition, it is
essential to signal that always a trade-off exists between the internal validity and the external
validity of a research. Usually, one research does not experience both high internal validity
and high external validity.
External validity
External validity reflects the extent to which the results can be generalized to the whole
population. In Figure 1 presented before, the external validity can be visually identified
through arrow 1.
Because in this desk research real world data is used, this thesis tends to have a relatively high
level of external validity. In addition, a sample selection as random as possible implies high
levels of external validity. In this thesis, the sample comprising public listed companies from
Italy, during a period of 9 years, i.e. 2005 up and included 2013, was randomly selected from
the Compustat Global database. Consequently, this thesis is considered to have a relatively
high level of external validity.
47
Construct validity
Construct validity reflects the extent to which one variable measures the underlying
theoretical construct that it is supposed to measure. In Figure 1 presented before, the construct
validity can be visually identified through arrows 2 and 3.
Measuring the independent variable, i.e. audit quality in a MAFR setting, implies computing
the audit tenure for each firm-year observation. In order to compute the audit tenure, the name
of the auditors for each firm-year observation is collected from the published annual reports.
Since the name of the auditors is observable in the annual reports of the companies, this
measurement is performed without any issues. Consequently the construct validity regarding
the independent variable is high.
On the other hand, measuring the dependent variable, i.e. the magnitude of the use of earnings
management, implies the estimation of the amount of discretionary accruals. Since
discretionary accruals are not directly observable, an estimation model is used, i.e. the
performance matched model by Kothari et Al. (2005). These estimates used in the model for
determining the amount of discretionary accruals cause certain construct validity issues.
Consequently, the construct validity regarding the dependent variable is relatively low. This
limitation will be further commented in section 8.2 of this thesis.
6.4. Sample
In order to test the hypotheses, a sample is extracted from the Compustat Global database.
The Compustat Global Database contains annual and quarterly report information of non-
American and non-Canadian listed companies. Annual report data is available in this database
starting from 1987. Furthermore, additional data is gathered from the next sources: Orbis
database, Thomson Research database and Thomson One Banker database. Orbis contains
financial information regarding 79 million companies worldwide for the last ten years.
Thomson Research provides electronic copies of the annual, intermediary and quarterly
financial reports and analysts’ coverage for 30.000 listed companies worldwide, with a time
range of 1993-present. Thomson One Banker contains financial data for listed companies
worldwide, providing data from the annual reports, for the period starting from 1993. A
detailed presentation of the data collection from these sources is presented next in this
chapter.
48
6.4.1. Sample Selection
In order to gain a proper understanding of the management’s behaviour, in terms of the
magnitude of the use of earnings management, in a real mandatory audit firm rotation, the
Italian setting will be used; consequently the sample used in this thesis will comprise non-
financial Italian public listed companies. Due to data gathering limitations regarding the
auditor tenure information, the sample period is 2005 up to and included 2013, a period in
which the information about the auditor is accessible. This limitation in addition restricts the
size of this thesis’s sample, since the information regarding the auditor tenure was manually
collected. Consequently, the biggest public listed companies in Italy in the initial sample were
included, comprising 92 unique firms. From this initial sample, 40 companies belonging to
the financial sector are excluded. In addition, 8 other companies are excluded from the sample
due to availability issues regarding the required data. Since the accrual measure requires data
from two consecutive years, the observations which had no information regarding the prior
year from the sample were deleted. Consequently, the final sample contains 364 firm-year
observations, with data available from 44 unique firms. The next table presents the description
of the final sample:
Firm-year observationsOriginal sample 835
Financial sector excluded -360Unavailable data excluded -111
FINAL SAMPLE 364Table 1 – Sample Description
In order to have a better understanding of the sample, Table 2 below presents in which way
this sample is structured, in the context of the auditor rotation.
Firm-year observationsYears before the final year 190Last year before rotation 35First year after rotation 35
Years after rotation, first year excluded 104TOTAL 364
Table 2 – Auditors’ Distribution in the Sample
Considering the fact that for certain observations it is impossible to establish when the auditor
was changed, the distinction presented in the table before is essential for understanding the
sample and especially for testing the second hypothesis. As the table shows, 35 observations
represent the first year of a new auditor, and another 35 observations represent the last year of
the previous auditor, before the mandatory rotation. In addition, 190 observations represent
49
the years before the final year of an auditor, for which the moment of the previous rotation is
unknown. Finally, 104 observations consist of years after the known rotation has been
performed.
6.4.2. Data Collection
As signalled before, the primary sample is collected from the Compustat Global database.
From this database, regarding the required variables for the accrual measure, the next data
will be collected,: current assets, current liabilities, total assets, total liabilities, cash and
marketable securities, current portion of the long-term debt, depreciation and amortization
expense, gross property, plant and equipment, total receivables and total revenues (sales).
Orbis database will be used to collect the information regarding the net income, used to
compute the return on the assets ratio and another control variable. In addition, Orbis and
Thomson One Banker databases will be used to collect missing financial data that was not
available in Compustat Global, while still other missing financial data will be manually
gathered from the scanned financial reports through Thomson Research database.
Concerning the auditor information, the names of the auditors of the companies in the sample
will be manually collected from the annual reports through Thomson Research database and
from the annual reports officially posted on the companies’ websites. The purpose of
gathering the names of the auditors in each year for the companies in the sample is to compute
the length of the auditor tenure and to establish when the auditor rotation has been performed.
Concerning that, all the databases used in collecting the data concerning the purpose of this
thesis require licenses, for accessing the information the Erasmus University of Rotterdam
student credentials will be used.
6.5. Summary
This chapter has presented the research design to be used for testing the hypotheses. First, the
research approach that in this thesis will be used is presented: quantitative research using a
desk research. Next, the methods for estimating the measure of the magnitude of the use of
earnings management, i.e. discretionary accruals, was presented: the performance matched
model of Kothari et Al. (2005). In addition, the control variables and the regression model for
testing the hypotheses have been presented. Finally, the validity framework and the sample
consisting of non-financial Italian listed companies for the period 2005 up to and included
2013 have been presented. In the next chapter the results will be presented.
50
Val
ues o
f the
dep
ende
nt
varia
ble
7. Results
In this chapter, the answer to the seventh sub-question of this thesis is provided: “What do the
statistical results of the empirical research present about the studied relationship?” . This
chapter is divided in three major sections. The first one presents the results of the performance
matched model by Kothari et Al. (2005) for estimating the discretionary accruals, while the
second one presents the results from testing the hypotheses signalled before in chapter 5.
Finally, in an attempt to identify the potential reasons for the differences in the outcomes a
comparison of the results acquired in the second section with prior research will be presented.
7.1. Quality Tests
Before running the regression for testing the hypotheses, further quality tests have been
performed.
7.1.1. Outliers
In order to assess the quality of the data in the sample of this thesis, an investigation of the
outliers is performed, by using the boxplot below.
As can be observed in this boxplot, six outliers were identified. When these unusual values of
the dependent variable, i.e. discretionary accruals scaled by total assets, are included in the
sample, the potential to result in an unclear or biased relationship between the independent
and dependent variables exists. Consequently, these outliers are eliminated from the sample,
as presented in Table 1b below. The boxplot below is the result of the outliers test after
excluding the unusual values identified in the previous boxplot.
51
Val
ues o
f the
dep
ende
nt
varia
ble
In addition, one more firm-year observation is excluded from the sample due to an unexpected
loss of the data.
Firm-year observationsOriginal sample 835
Financial sector excluded -360Unavailable data excluded -111
Other data excluded -1Outliers excluded -6FINAL SAMPLE 357
Table 1b – Sample Description After Eliminating the Outliers
In addition, Table 2b below presents the distribution of the sample after eliminating the
outliers.
Firm-year observationsYears before the final year 187Last year before rotation 35First year after rotation 35
Years after rotation 100TOTAL 357
Table 2b – Auditors’ Distribution in the Sample After Eliminating the Outliers
7.1.2. Normal Distribution of the Sample
Before performing the statistical tests using the sample signalled before, the data need to be
tested for normality. In order to be able to perform linear regression, the data should be
normally distributed. Testing for normal distribution can be performing in two ways:
numerically and graphically. To assess the data distribution of the sample both approaches in
this thesis are used. First, the significance of ,006 in the Kolmogorov-Smirnov test, as shown
in Table 4 below, suggests that the sample used in this thesis is significantly different from an
abnormal distribution.
52
Tests of Normality
Kolmogorov-Smirnova Shapiro-Wilk
Statistic df Sig. Statistic df Sig.
DA/At-1 ,058 357 ,006 ,982 357 ,000
a. Lilliefors Significance CorrectionTable 4 – Tests of Normality
From the graphical point of view, the next two graphs are relevant for assessing the normality
of this sample. First, a normally distributed sample is graphically characterized by a bell-
shaped histogram. Although it is not an ideal normal distribution, the histogram presented
next shows that this thesis’s sample follows the trend of a normally distributed sample.
A normal Q-Q plot is another tool that can help assessing the normal distribution of a sample.
A straight diagonal line would be the ideal normality in this case. The plot presented next
shows that the sample used in this thesis follows, to a certain extent, the diagonal line.
53
7.1.3. Homoscedasticity
Another requirement for running the regression is the homoscedasticity. In order to be able to
perform linear regression, in the sample homoscedasticity should exist.
The results of the tests for homoscedasticity can be observed in the boxplot below, which
shows that in the sample homoscedasticity exists, as indicated by the straight fit line.
7.1.4. Multicollinearity
The last quality test performed for this thesis is regarding the multicollinearity. In order to be
able to perform linear regression, in the sample regarding the variables included in the model
multicollinearity should not exist.
The results of the tests for multicollinearity can be observed in the tables below, which show
that multicollinearity is not an issue, as indicated by the VIF values which are around 1.
Coefficientsa
Model
Collinearity Statistics
Tolerance VIF
1 ctr_size ,984 1,017
ctr_growth ,985 1,016
ctr_leverage ,962 1,039
ctr_PriorLoss ,976 1,025
a. Dependent Variable: audit tenure
54
Coefficientsa
Model
Collinearity Statistics
Tolerance VIF
1 ctr_size ,984 1,017
ctr_growth ,985 1,016
ctr_leverage ,962 1,039
ctr_PriorLoss ,976 1,025
Coefficientsa
Model
Collinearity Statistics
Tolerance VIF
1 ctr_growth ,960 1,042
ctr_leverage ,974 1,027
ctr_PriorLoss ,967 1,034
Audit tenure ,966 1,035
a. Dependent Variable: ctr_size
Coefficientsa
Model
Collinearity Statistics
Tolerance VIF
1 ctr_leverage ,969 1,032
ctr_PriorLoss ,974 1,027
Audit tenure ,991 1,009
ctr_size ,984 1,017
a. Dependent Variable: ctr_growth
Coefficientsa
Model
Collinearity Statistics
Tolerance VIF
1 Audit tenure ,976 1,025
ctr_size ,985 1,015
ctr_growth ,968 1,033
ctr_leverage ,974 1,027
a. Dependent Variable: ctr_PriorLoss
Coefficientsa
Model Collinearity Statistics
55
Coefficientsa
Model
Collinearity Statistics
Tolerance VIF
1 ctr_size ,984 1,017
ctr_growth ,985 1,016
ctr_leverage ,962 1,039
ctr_PriorLoss ,976 1,025
Tolerance VIF
1 ctr_PriorLoss ,978 1,022
Audit tenure ,967 1,034
ctr_size ,997 1,003
ctr_growth ,968 1,033
a. Dependent Variable: ctr_leverage
56
7.2. Earnings Management Model Results
For estimating the amount of the discretionary accruals for the firms in this thesis’s sample, in
this section the performance matched model of Kothari et Al. (2005) will be performed. As
signalled before, the amount of the discretionary accruals is used as a proxy for the magnitude
of the use of earnings management. The steps for the estimation of discretionary accruals are
described in section 6.2.1 of this thesis. After finishing the first step of the discretionary
accruals estimation, i.e. computing the amount of Total Accruals (TAit), estimating the
coefficients b0, b1, b2 and b3 based on the next equation, in SPSS a regression needs to be
run:
TAit/Ait-1 = b0 [1/Ait-1] + b1 [ΔREVit / Ait-1 - ΔRECit / Ait-1] + b2 [PPEit / Ait-1] +b3 ROAit-1 + εit
Before running this regression further quality tests have been performed. The results of the
tests for the multicollinearity and the homoscedasticity can be observed in Appendix 3, which
show that multicollinearity is not an issue, as indicated by the VIF values which are within the
interval [1,2], and that homoscedasticity exists in the sample, as indicated by the straight fit
line in the scatterplot.
The results of the regression before are presented in Table 7 below. In addition, the
descriptive statistics of this test are presented in Appendix 3, Table 5 and Table 6.
Coefficientsa
Model
Unstandardized
Coefficients
Standardized
Coefficients
t Sig.B Std. Error Beta
1 (Constant) -,062 ,013 -4,699 ,000
1/At-1 33,842 27,338 ,081 1,238 ,217
(REVt-RECt)/At-1 ,161 ,021 ,399 7,538 ,000
PPEt/At-1 ,017 ,015 ,062 1,137 ,256
ROAt-1/At-1 -714,490 408,728 -,112 -1,748 ,081
a. Dependent Variable: TAt/At-1
Table 7 – BETAs Coefficients
Based on the table 7 before, a positive relationship exists between the first independent
variable, i.e. 1/At-1, and the dependent variable. However, the p-value of 0,217 indicates that
the coefficient b0 is not significant at a 5% level. Concerning the second independent variable,
i.e. (REVt-RECt)/At-1, a positive association with the dependent variable exists with a p-value
of 0,000 which indicates that b1 is significant at a 5% level. In addition, the relationship
57
between the third independent variable, i.e. PPEt/At-1, and the dependent variable is positive,
with a p-value of 0,256 which indicates that b2 is not significant at a 5% level. Finally, a
negative correlation exists between ROAt-1/At-1 and the dependent variable, which can be
explained by the assumption that firms with good performance report lower accruals. The p-
value for this variable is 0,081 that indicate that b3 is not significant at a 5% level.
7.3. Hypotheses Testing Results
In this section, the outcomes of the hypotheses tests are presented.
7.3.1. Hypothesis 1
H1
The magnitude of the use of earnings management increases gradually as the auditor tenure
increases, positive correlation.
In order to test the first hypothesis, in SPSS the next regression is run:
DAit/Ait-1 = β0 + β1ATit + β2SIZEit + β3GROWTHit + β4LEVERAGEit + β5PRIOR_LOSSit + εit
As signalled before, in order to assess the first hypothesis, the β1 coefficient will be observed.
For the prediction to be confirmed, the expectation for the β1 coefficient is to be significant
and statistically significant.
The results of this regression are presented in Table 10 below. In addition, the descriptive
statistics of this test are presented in Appendix 4, Table 8 and Table 9.
Coefficientsa
Model
Unstandardized Coefficients
Standardized
Coefficients
t Sig.B Std. Error Beta
1 (Constant) -,010 ,032 -,311 ,756
Audit tenure ,004 ,002 ,123 2,330 ,020
ctr_leverage -,039 ,027 -,075 -1,415 ,158
ctr_size -,008 ,003 -,125 -2,374 ,018
ctr_growth ,032 ,014 ,118 2,231 ,026
ctr_PriorLoss -,018 ,013 -,074 -1,406 ,161
a. Dependent Variable: DAt/At-1
Table 10 – Coefficients
58
Based on Table 10, the conclusion regarding the first hypothesis can be drawn. The β1
coefficient of 0,004 indicates a positive relationship between the main independent variable,
i.e. audit tenure, and the dependent variable, i.e. DAt/At-1. In other words, by the positive
correlation between the length of the auditor-client relationship and the magnitude of the use
of earnings management, measured by discretionary accruals, hypothesis 1 is confirmed. In
addition, the p-value of 0,020 indicates that the β1 coefficient is statistically significant at a 5%
level.
7.3.2. Hypothesis 2
H2
The magnitude of the use of earnings management drops in the first year when a new auditor
is appointed.
The findings concerning hypothesis 2 are presented in the two charts below:
54.29%
45.71%
Distribution of DA trends (%)
Lower discretionary accruals in the first year after rotation than the year beforeHigher discretionary accruals in the first year after rotation than the year before
Chart 1 – Distribution of DA trends (%)
59
Higher discretionary accruals in the first year after rotation than the year before
Lower discretionary accruals in the first year after rotation than the year before
0tan28aa566028
0tan4aa56604
0tan9aa56609
0tan14aa566014
0tan19aa566019
0tan24aa566024
0tan29aa566029
0tan15aa5660150tan18aa566018
Distribution of DA trends
Chart 2 – Distribution of DA trends
In order to test this hypothesis, an assessment regarding the amounts of the discretionary
accruals in the years right before and in the years after the auditor rotation needs to be
performed. The sample used in this thesis contains 35 auditor rotations. In 19 cases of
rotation, the amount of discretionary accruals in the first year after a new auditor has been
appointed is lower than in the year before the rotation. That implies that 54,29% of the
rotations support the second hypothesis. On the other hand, in 16 cases of the rotation the
amount of the discretionary accruals increases in the first year after the rotation.
Since the evidence is not very conclusive, based on these findings, it is difficult to conclude
whether hypothesis 2 can be confirmed or rejected. In addition, the assessment of this
hypothesis is restricted by the limited number of rotations in the sample used in this thesis.
Consequently, expressing an opinion regarding the impact of these inconclusive results
regarding hypothesis 2 on answering the main research question is restricted by the
statistically insufficiency of the data. However, the management’s behaviour in a mandatory
audit firm rotation setting can still be properly assessed based on the results of the first
hypothesis.
7.4. Comparison with Prior Research
In this section, the results of the empirical research performed in this thesis, and presented
before in this chapter, are compared with the results of three papers from prior research: Davis
et Al. (2000), Myers et Al. (2003) and Chen et Al. (2008).
60
Number of rotations
7.4.1. Comparison to Davis et Al. (2000)
As signalled before in chapter 4, Davis et Al. (2000) studied the relationship between the
length of the auditor tenure and the amount of the discretionary accruals. The main difference
of Davis et Al. (2000) approach, compared to the approach used in this thesis, is that they use
the distinction between the absolute and the signed discretionary accruals, and they studied
the relationship for each, individually. Their results can be observed in Table 11 below:
Absolute and Signed Discretionary Accruals Regression Results by Number of Auditors Parameters (t-statistics)
Single Auditor Multiple Auditor
Variables
Absolute D.
Accruals
Discretionary Accruals
Absolute D.
Accruals
Discretionary Accruals
INTERCEPT 0,153*** 0,071*** 0,246*** 0,039(6,909) (2,699) (8,861) (1,165)
TENURE 0,004*** -0,002** 0,001 -0,006*(4,369) (-2,240) (0,287) (-1,899)
GCU -0,059* -0,030 0,000 -0,131**(-1,648) (-0,611) (0,006) (-2,419)
CTG -0,044* -0,049* -0,104*** -0,123***(-1,818) (-1,663) (-4,049) (-3,545)
BIG5 0,060*** 0,015 0,036 0,026(3,023) (0,651) (1,400) (0,858)
ATACC 0,590*** 0,104 0,316*** 0,241***(11,465) (0,897) (4,002) (2,687)
CFOP 0,002 -0,294*** 0,013 -0,395***(0,058) (-4,416) (0,262) (-6,341)
LASTYR - - -0,051 -0,041(-1,302) (-0,904)
FIRSTYR - - -0,018 -0,046(-0,638) (-1,363)
Adj R2 0,014 0,005 0,004 0,017
Table 11 – Results of Davis et Al. (2000)
Another significant difference in the approaches is that Davis et Al. (2000) have split their
sample in two sub-samples: one with only one auditor, i.e. no rotations during the observed
period, and one with multiple auditors, i.e. at least one rotation during the observed period. In
61
this thesis, this split was restricted by the size of the sample. Concerning the actual results, the
most relevant comparison is the coefficient of the audit tenure variable in the single auditor
sample for the signed discretionary accruals. The coefficient that indicates the relationship
between the audit tenure and the discretionary accruals has a value of -0,002 in the single
auditor sub-sample. This implies a negative association, which is the opposite of what this
thesis has found. In addition, the results from the multiple auditor sample indicate a negative
association as well, but more powerful, with a coefficient of -0,006.
In conclusion, the results of this thesis are not in conformity with the findings of Davis et Al.
(2000). It is essential to signal that the results of Davis et Al. (2000) are based on a sample
from the period 1981 up to and included 1998 in a non-mandatory audit firm rotation setting.
7.4.2. Comparison to Myers et Al. (2003)
Myers et Al. (2003) have studied the relationship between the length of the auditor tenure and
the quality of the published earnings. They approach the quality of the published earnings by
measuring it through the amount of the discretionary accruals, as used in this thesis. The main
difference of Myers et Al. (2003) approach, compared to the approach used in this thesis, is
that they in addition used current accruals as a proxy for the quality of the published earnings.
They studied the relationship for the current accruals and the discretionary accruals,
individually. Their results can be observed in Table 12 below:
Panel A: Absolute Value MeasuresVariable Discretionary Accruals Current AccrualsIntercept 0,19275 0,25324
[< 0,0001] [< 0,0001]Tenure| -0,00037 -0,00142
[0,0041] [0,0004]Age -0,00038 -0,00393
[0,0121] [< 0,0001]Size -0,01148 -0,01032
[< 0,0001] [< 0,0001]Industry Growth -0,00305 0,00432
[0,2348] [0,5807]Cash Flow -0,05453 -0,18027
[< 0,0001] [< 0,0001]Auditor Type -0,00356 0,01283
[0,0146] [0,0039]N 41.250 41.250
Table 12 – Results of Myers et Al. (2003)
62
Based on the results in the table before, the findings of Myers et Al. (2003) concerning the
amount of the discretionary accruals indicate an opposite relationship compared to the results
of this thesis. The coefficient that indicates the association between the audit tenure and the
discretionary accruals is negative, i.e. -0,00037. That implies that the length of the auditor-
client relationship has a negative effect on the amount of the discretionary accruals. However,
it is essential to notice that the effect is less powerful than the effect found in this thesis. A
possible explanation for the difference in the results relies on the setting used in the tests.
While this thesis tests this relationship in a real MAFR setting, Myers et Al. (2003) use a
sample from US, in which mandatory rotation is not implemented. However, it is interesting
to notice that these findings are in conformity with the findings of Davis et Al. (2000); they
both used the same setting: the US, and, to some extent, a similar sample period: 1988 up to
and included 2000.
7.4.3. Comparison to Chen et Al. (2008)
Chen et Al. (2008) have the studied the same relationship as Myers et Al. (2008): the effect
the audit firm tenure has on the quality of the published earnings, using the discretionary
accruals as a proxy for the quality of the published earnings. The main difference in the
approach of Chen et Al. (2008) compared to the approach used in this thesis is that, for testing
the association audit firm tenure – the amount of discretionary accruals, in their model they
added the partner tenure as a control variable. Their results are presented in Table 13 below:
DiscAccr = β0 + β 1PT + β2FT +β3ΒIG5 + β4AGE + β5SIZE + β6GROW + β7CFO + δ·Year + γ·Industry + ε
DiscAccr =*Variable |DA| DA DA+ DA-PT -0,0006 0,0002 -0,002 0,0009
(-1,78)§ (0,39) (-1,47) (0,49)FT -0,0008 -0,0002 -0,0011 0,0018
(-2,23)‡ (-0,51) (-0,79) (0,93)PT+FT (b1 + b2) -0,0014 -0,0000 -0,0033 0,0027
(-4,73)† (-0,12) (-2,85)† (1,74)§
Adjusted R2 0,1991 0,4543 - -Number of obs. 5.213 5.213 2.595 2.618
Table 13 – Results of Chen et Al. (2008)
The variable of interest for the assessment of Chen’s et Al. (2008) results is audit firm tenure
(FT). A negative coefficient with the value – 0,0002 exists, which indicates a negative
association between the audit firm tenure and the amount of the discretionary accruals (DA).
63
These results are in conformity with the results of Myers et Al. (2003), suggesting that the
longer the auditor-client relationship, the lower the magnitude of the use of earnings
management. However, it is essential to notice that the effect is weaker than the effect found
in this thesis. A possible explanation for the difference in the results relies on the setting used
in Chen et Al. (2008) tests. The Taiwan setting does not have a mandatory audit firm rotation
rule implemented, which could explain the difference in the management’s behaviour.
Moreover, the Taiwanese setting implies certain specific characteristics which could have an
impact on the results.
7.5. Summary
In this chapter, the results of the empirical research have been presented. First, the estimation
process for the discretionary accruals using the performance matched model by Kothari et Al.
(2005) has been presented. Next, the results regarding the hypotheses have been displayed.
The findings confirm the first hypothesis, which suggests a significant positive correlation
between the length of the audit tenure and the magnitude of the use of earnings management,
measured by the discretionary accruals. Since the findings were not very conclusive, the
second hypothesis was neither confirmed nor rejected,. Consequently, in order to assess
whether the amount of discretionary accruals consistently drops in the first year after the
auditor rotation compared to the previous year, further investigations using more extensive
data is required. Finally, a comparative assessment of these findings related to prior research
has been commented.
In the next chapter, the concluding remarks of this thesis will be presented.
64
8. Conclusions
This chapter answers the last research sub-question of this thesis: “Which conclusions are
derived from the analysis of the statistical results and the comparison with results of prior
research?”.
In this chapter, the concluding remarks of this thesis will be presented. In addition, comments
on the limitations of this thesis will be presented. Finally, recommendations for future
research will be presented.
8.1. Concluding Remarks
To summarize the findings of this thesis, significant evidence has been found to support
hypothesis 1. The empirical tests indicate a positive correlation between the audit firm tenure
and the magnitude of the use of earnings management in a mandatory audit firm rotation
setting. These findings regarding hypothesis 1 answer the biggest part of the main research
question of this thesis and implies that, in a mandatory audit firm rotation setting, managers
engage more in earnings management when the length of the auditor-client relationship is
longer. In other words, it can be concluded that the implementation of the mandatory audit
firm rotation has a significant impact on the management’s behaviour in terms of the use of
earnings management. That is, by imposing a limited period for retaining the same auditor,
managers tend to engage less in the use of earnings management.
Concerning hypothesis 2, on the other hand, the evidence is inconclusive, which implies that a
proper assessment of this hypothesis is restricted. Consequently, since the findings rely on a
small collection of 70 observations in which rotations of the auditors can be analysed, i.e. 35
rotations, hypothesis 2 cannot be either accepted, or rejected,. Based on this sub-sample, the
findings regarding hypothesis two suggest that in 54,29% of the cases, the amount of the
discretionary accruals drops, compared to the year before the rotation. That is, managers
engage less in earnings management in the first year after a new auditor has been appointed.
This supports, to a certain extent, the assumption that a ‘fresh’ auditor would impose more
restrictions in the flexibility of managers when it comes to manipulating the discretionary
accruals. However, due to the limited number of the observations regarding this effect, the
findings are difficult to generalize, and consequently, a proper conclusion concerning
hypothesis 2 cannot be drawn. Further comments regarding this situation are presented in the
next sections of this chapter.
65
Comparing the findings of this thesis with the results from prior research, i.e. Davis et Al.
(2000), Myers et Al. (2003) and Chen et Al. (2008), it is interesting to notice that, while the
three papers from prior research indicate a negative association between the audit tenure and
the amount of discretionary accruals, the findings of this thesis suggest the contrary: a
significant positive association. Considering that the three papers signalled before tested this
relationship in non-mandatory rotation environments, i.e. the US and Taiwan, the assumption
is that the mandatory audit firm rotation setting used in this thesis, i.e. Italy, had a significant
impact on the results. That is, the MAFR setting causes a change in the behaviour of the
management in terms of the use of earnings management, when compared to the
management’s behaviour in the non-mandatory systems. Hence, the main research question is
answered: in a MAFR setting, managers tend to engage more in earnings management when
the audit tenure increases.
Compared to the existing scientific literature regarding the mandatory audit firm rotation, this
thesis has two main advantages, which present a significant contribution to the academic
literature in this topic. First, the majority of the existing empirical papers try to assess the
effectiveness of a mandatory audit firm rotation rule or to provide an understanding of the
auditor’s behaviour in a MAFR setting. However, this is not the object of this thesis. This
thesis provides with a better understanding of the management’s behaviour in terms of the use
of earnings management in the context of the mandatory audit firm rotation.
Second, while most papers concerning the mandatory audit firm rotation are based on settings
in which mandatory rotation is not in place, this thesis tests the relationship in a real MAFR
setting.
In addition, by showing evidence to support the claims of the advocates of mandatory audit
firm rotation, this thesis contributes to the debate surrounding the MAFR rule. Consequently,
it could emerge as a springboard for future research in this field, and appeal to more attention
from researchers to this topic.
8.2. Limitations
The main limitation concerning this thesis relies on the assumption that management can
employ two types of earnings management: accrual based earnings management and real
earnings management. Most of the times, when managing the published earnings managers
use both approaches. Because real earnings management is difficult, if not impossible, to
detect, in this thesis the use of accrual earnings management is investigated. Since real
66
earnings management is not included in this thesis’s model, this implies a certain limitation
concerning this thesis,. In addition, Graham et Al. (2005) found that managers, in order to
manage the reported earnings, prefer to manipulate the real activities rather than manipulating
the accruals (Graham, Harvey, & Rajgopal, 2005). Consequently, this situation could have a
consequence on the results of this thesis.
Since the model used in this thesis for measuring the discretionary accruals, i.e. the
performance matched model by Kothari et Al. (2005), involves estimates, another limitation
arises from the construct validity issues regarding the measurement of the discretionary
accruals.
In addition, correlated omitted variables could exist, other than the ones included in the model
as control variables, i.e. firm size, sales growth, leverage and the existence of a loss in the
prior year.
Finally, since the observations which experienced auditor rotations were limited, a limitation
has arisen from testing hypothesis 2. The inconclusive evidence regarding this hypothesis
causes a drawback of this thesis.
8.3. Recommendations for Future Research
Probably the most important recommendation for future research is to address real earnings
management in addition to the accrual based earnings management in the studies related to
this topic. As signalled before, including real earnings management can have an essential
impact in the research of this field, and could improve the validity of the academic research
when studying the use of earnings management.
Another recommendation addresses the results of this thesis regarding hypothesis 2. This
hypothesis tested whether the amount of the discretionary accruals drops in the first year after
an auditor rotation. A proper conclusion regarding this effect would significantly contribute to
the understanding of the management’s behaviour in a mandatory audit firm rotation setting.
Consequently, the recommendation is to investigate this effect using more extensive data in
order to be able to form a reliable conclusion about the magnitude of the use of earnings
management in the first year after a new auditor was appointed.
67
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71
Appendices
Appendix 1: Summary table of the literature review
Out
com
es
No
conc
lusi
ve e
vide
nce
rega
rdin
g th
e co
rrel
atio
n be
twee
n th
e ec
onom
ic
depe
nden
ce a
nd th
e pr
obab
ility
of i
ssui
ng a
go
ing-
conc
ern
audi
t rep
ort
both
per
iods
. Si
gnifi
cant
evi
denc
e sh
owin
g a
posi
tive
effe
ct
thos
e au
dito
rs’ i
ncen
tives
to
mai
ntai
n re
puta
tion
have
on
the
prob
abili
ty o
f is
suin
g go
ing-
conc
ern
opin
ions
in th
e po
st-
man
dato
ry ro
tatio
n pe
riod.
Whe
n us
ing
the
first
m
easu
re, i
.e. t
he
prop
ensi
ty o
f iss
uing
a
goin
g co
ncer
n op
inio
n, th
e fin
ding
s ind
icat
e a
posi
tive
corr
elat
ion
betw
een
audi
t te
nure
and
aud
it qu
ality
.W
hen
usin
g th
e se
cond
m
easu
re, i
.e. d
iscr
etio
nary
ac
crua
ls, e
vide
nce
show
no
ass
ocia
tion
betw
een
audi
t ten
ure
and
audi
t qu
ality
.
Met
hodo
logy
Reg
ress
ion
anal
ysis
that
ex
plor
es th
e pr
open
sity
of
the
goin
g co
ncer
n op
inio
ns in
two
perio
ds:
man
dato
ry ro
tatio
n pe
riod
and
post
-man
dato
ry
rota
tion
perio
d.
Aud
it qu
ality
is m
easu
red
usin
g tw
o pr
oxie
s: th
e pr
open
sity
of a
goi
ng
conc
ern
opin
ion
bein
g is
sued
by
the
audi
tor,
and
disc
retio
nary
acc
rual
s. R
egar
ding
the
first
m
easu
re, a
mod
el th
at
incl
udes
the
clie
nt’s
fin
anci
al ri
sk, l
iabi
litie
s to
asse
ts ra
tio, n
et c
ash
flow
an
d ot
her r
atio
s as
varia
bles
, is u
sed.
C
once
rnin
g th
e di
scre
tiona
ry a
ccru
als,
they
are
est
imat
ed u
sing
th
e pe
rfor
man
ce-m
atch
ed
mod
ified
Jone
s mod
el.
Dat
a so
urce
s
Dat
abas
e of
the
Span
ish
Secu
ritie
s and
Exc
hang
e C
omm
issi
on (C
omis
io´n
N
acio
nal d
el M
erca
do d
e V
alor
es, C
NM
V).
Cra
swel
l’s “
Who
aud
its
Aus
tralia
” da
taba
se, A
SX
web
site
, Asp
ect H
untle
y’s
Dat
Ana
lysi
s, C
onne
ct 4
, Th
omps
on’s
SD
C
Plat
inum
New
Issu
es
Dat
abas
e, C
RIF
.M
issi
ng d
ata
man
ually
co
llect
ed fr
om o
ther
re
leva
nt so
urce
s.
Sam
ple
1326
fina
ncia
l dis
tress
ed
firm
s fro
m S
pain
from
the
perio
d 19
91-2
000,
with
a
tota
l of 3
.119
firm
yea
r ob
serv
atio
ns. C
ompa
nies
fr
om th
e fin
anci
al se
rvic
es
and
insu
ranc
e in
dust
ry, a
s w
ell a
s alre
ady
in
liqui
datio
n co
mpa
nies
, w
ere
excl
uded
from
the
sam
ple.
205
audi
tor s
witc
hes i
n A
ustra
lian
publ
ic li
sted
A
SX c
ompa
nies
from
the
perio
d 19
95-2
003,
with
a
tota
l of 1
.750
firm
yea
r ob
serv
atio
ns. C
ompa
nies
fr
om th
e fin
anci
al se
ctor
, co
mpa
nies
repo
rting
in
fore
ign
curr
enci
es, a
nd
com
pani
es w
ith
inco
mpl
ete
data
wer
e ex
clud
ed fr
om th
e sa
mpl
e.
Subj
ect
The
effe
ct
man
dato
ry a
udit
firm
rota
tion
has o
n th
e in
depe
nden
ce
of th
e au
dito
r.
The
effe
ct o
f th
e te
nure
in
audi
tor-
clie
nt
rela
tions
hip
on
the
qual
ity o
f au
dit.
72
Aut
hors
Rui
z-B
arba
dillo
, G
omez
-Agu
ilar
& C
arre
ra
(200
8)
Jack
son,
M
oldr
ich
& R
oebu
ck
(200
9)
Out
com
es
Aud
it qu
ality
has
the
tend
ency
to b
e hi
gher
in th
e ye
ars p
rece
ding
the
man
dato
ry ro
tatio
n, i.
e.
whe
n au
dito
r ten
ure
is
long
er. T
he in
vest
ors’
pe
rcep
tion
of th
e qu
ality
of
audi
t fol
low
s the
sam
e tre
nd
as th
e ac
tual
aud
it qu
ality
, te
ndin
g to
be
high
er in
the
last
yea
rs o
f the
en
gage
men
t.
The
test
s rev
eal t
hat
com
pani
es a
udite
d by
non
-B
igSi
x au
dito
rs e
ncou
nter
si
gnifi
cant
ly la
rger
am
ount
s of
dis
cret
iona
ry a
ccru
als,
i.e.
1.5%
of a
sset
s hig
her.
Posi
tive
asso
ciat
ion
betw
een
audi
tor t
enur
e an
d ab
solu
te
disc
retio
nary
acc
rual
s and
ne
gativ
e as
soci
atio
n be
twee
n au
dito
r ten
ure
and
abso
lute
fore
cast
err
ors.
Neg
ativ
e as
soci
atio
n be
twee
n au
dito
r ten
ure
and
sign
ed d
iscr
etio
nary
ac
crua
ls a
nd p
ositi
ve
asso
ciat
ion
betw
een
audi
tor
tenu
re a
nd si
gned
fore
cast
er
rors
.
Met
hodo
logy
In o
rder
to a
sses
s how
aud
it qu
ality
va
ries o
ver t
he e
ngag
emen
t of t
he
audi
tor i
n a
real
man
dato
ry a
udit
firm
rota
tion
setti
ng, a
udit
qual
ity is
m
easu
red
by u
sing
abn
orm
al
wor
king
cap
ital a
ccru
als a
s a p
roxy
. A
dditi
onal
ana
lysi
s is p
erfo
rmed
by
the
rese
arch
ers,
test
ing
for t
he e
ffec
t m
anda
tory
aud
it fir
m ro
tatio
n ha
s on
the
perc
eive
d au
dit q
ualit
y, u
sing
the
earn
ings
resp
onse
coe
ffic
ient
as a
pr
oxy.
The
tool
use
d fo
r det
ectin
g an
d m
easu
ring
the
use
of e
arni
ngs
man
agem
ent i
s the
cro
ss-s
ectio
nal
vers
ion
of th
e Jo
nes m
odel
for
estim
atin
g di
scre
tiona
ry a
ccru
als.
Con
sequ
ently
, a m
ultiv
aria
te a
naly
sis
is p
erfo
rmed
for t
estin
g th
e hy
poth
esis
.
The
use
of e
arni
ngs m
anag
emen
t is
mea
sure
d th
roug
h di
scre
tiona
ry
accr
uals
, est
imat
ed w
ith a
mod
ified
ve
rsio
n of
the
Jone
s mod
el.
Con
cern
ing
the
abili
ty o
f the
m
anag
ers t
o m
eet t
he a
naly
sts’
fo
reca
sts,
a m
odel
is d
esig
n fo
r m
easu
ring
the
fore
cast
err
or, b
y in
clud
ing
the
fore
cast
hor
izon
, the
nu
mbe
r of a
naly
sts,
and
the
fore
cast
di
sper
sion
as v
aria
bles
. Tw
o ty
pes o
f te
sts a
re p
erfo
rmed
: tes
ts a
ddre
ssin
g ab
solu
te d
iscr
etio
nary
acc
rual
s and
ab
solu
te fo
reca
st e
rror
s, an
d te
sts
addr
essi
ng si
gned
dis
cret
iona
ry
accr
uals
and
sign
ed fo
reca
st e
rror
s.
Dat
a so
urce
s
Cal
epin
o de
ll’az
ioni
sta,
A
ida
data
base
, Tac
cuin
o de
ll’az
ioni
sta,
a
publ
icat
ion
edite
d by
Il
Sole
24
Ore
, the
mos
t po
pula
r eco
nom
ic a
nd
finan
cial
pub
licat
ion
in
Italy
.
Com
pust
at d
atab
ase
Com
pust
at d
atab
ase
LEX
IS/N
EXIS
NA
AR
SI/B
/E/S
Sam
ple
171
non-
finan
cial
Ital
ian
com
pani
es li
sted
at t
he M
ilan
Stoc
k Ex
chan
ge fr
om th
e pe
riod
1985
-200
4, w
ith a
tota
l of
1.1
84 fi
rm y
ear
obse
rvat
ions
.
A to
tal o
f 12.
558
firm
yea
r ob
serv
atio
n fr
om th
e U
S,
9.03
5 w
ith B
igSi
x au
dito
rs
and
1.84
6 w
ith n
on-B
igSi
x au
dito
rs. F
inan
cial
ent
ities
an
d ut
ility
com
pani
es a
re
excl
uded
from
the
sam
ple.
846
firm
s fro
m th
e pe
riod
1981
-199
8, w
ith a
tota
l of
12.8
92 fi
rm y
ear
obse
rvat
ions
, div
ided
in tw
o su
b-sa
mpl
es: 5
85 fi
rms t
hat
did
not c
hang
e th
eir a
udito
rs
durin
g th
e ob
serv
ed p
erio
d,
and
261
firm
s tha
t cha
nged
th
eir a
udito
rs a
t lea
st o
nce.
C
ompa
nies
from
the
finan
cial
an
d se
rvic
e se
ctor
s are
ex
clud
ed fr
om th
e sa
mpl
e.
Subj
ect
The
effe
ct o
f m
anda
tory
aud
it fir
m ro
tatio
n on
th
e qu
ality
of
audi
t.
The
effe
ct o
f th
e qu
ality
of
audi
t on
the
use
of e
arni
ngs
man
agem
ent.
The
effe
ct o
f th
e le
ngth
of t
he
audi
tor t
enur
e on
the
mag
nitu
de o
f th
e us
e of
ea
rnin
gs
man
agem
ent.
73
Aut
hors
Cam
eran
, Pr
enci
pe
& T
rom
betta
(2
012)
Bec
ker,
DeF
ond,
Jiam
balv
o &
Su
bram
anya
m
(199
8)
Dav
is, S
oo&
Tro
mpe
ter
(200
0)
Out
com
es
Neg
ativ
e as
soci
atio
n be
twee
n th
e au
dito
r ten
ure
and
the
disp
ersi
on o
f the
cu
rren
t and
the
disc
retio
nary
acc
rual
s.
Neg
ativ
e co
rrel
atio
n be
twee
n th
e au
dit p
artn
er
tenu
re a
nd th
e le
vel o
f the
di
scre
tiona
ry a
ccru
als.
Neg
ativ
e co
rrel
atio
n be
twee
n th
e au
dit f
irm
tenu
re a
nd th
e le
vel o
f the
di
scre
tiona
ry a
ccru
als,
afte
r con
trolli
ng fo
r pa
rtner
tenu
re.
Met
hodo
logy
Two
prox
ies a
re u
sed
for
mea
surin
g th
e ea
rnin
gs
qual
ity, c
urre
nt a
ccru
als
and
disc
retio
nary
acc
rual
s. B
oth
univ
aria
te a
nd
mul
tivar
iate
test
s are
pe
rfor
med
for t
estin
g th
e hy
poth
eses
.
Dis
cret
iona
ry a
ccru
als a
re
mea
sure
d us
ing
a cr
oss-
sect
iona
l ver
sion
of t
he
mod
ified
Jone
s mod
el.
Two
hypo
thes
es a
re
test
ed, o
ne re
gard
ing
the
effe
ct o
f par
tner
tenu
re,
and
one
rega
rdin
g th
e ef
fect
of a
udit
firm
tenu
re,
afte
r con
trolli
ng fo
r the
pa
rtner
tenu
re. M
odel
s are
de
sign
ed fo
r tes
ting
thes
e hy
poth
eses
, inc
ludi
ng th
e ag
e of
the
com
pany
, its
si
ze a
nd g
row
th, a
s va
riabl
es.
Dat
a so
urce
s
Com
pust
at d
atab
ase.
Taiw
an E
cono
mic
Jour
nal
(TEJ
) dat
abas
e
Sam
ple
42.3
02 fi
rm y
ear
obse
rvat
ions
from
the
US
from
the
perio
d 19
88-
2000
.
888
Taiw
anes
e co
mpa
nies
fr
om th
e pe
riod
1990
-20
01, w
ith a
tota
l of 5
.213
fir
m y
ear o
bser
vatio
ns.
Item
s tha
t hav
e an
initi
al
publ
ic o
ffer
ing
in th
e cu
rren
t or p
revi
ous y
ear
are
excl
uded
from
the
sam
ple.
Subj
ect
The
effe
ct o
f th
e au
dito
r-cl
ient
re
latio
nshi
p in
te
rms o
f ten
ure
on th
e qu
ality
of
ear
ning
s.
The
effe
ct o
f au
dit f
irm
tenu
re o
n th
e qu
ality
of t
he
publ
ishe
d ea
rnin
gs.
74
Aut
hors
Mye
rs, M
yers
&
Om
er (2
003)
Che
n, L
in, &
Li
n(2
008)
Appendix 2: Sample Information
Appendix 2.1: Sample description
Firm-year observationsOriginal sample 835
Financial sector excluded -360Unavailable data excluded -111
FINAL SAMPLE 364Table 1 – Sample Description
Firm-year observationsOriginal sample 835
Financial sector excluded -360Unavailable data excluded -111
Other data excluded -1Outliers excluded -6FINAL SAMPLE 357
Table 1b – Sample Description After Eliminating the Outliers
Appendix 2.2: Auditors’ distribution in the sample
Firm-year observationsYears before the final year 190Last year before rotation 35First year after rotation 35
Years after rotation, first year excluded 104TOTAL 364
Table 2 – Auditors’ Distribution in the Sample
Firm-year observationsYears before the final year 187Last year before rotation 35First year after rotation 35
Years after rotation 100TOTAL 357
Table 2b – Auditors’ Distribution in the Sample After Eliminating the Outliers
75
Appendix 2.3: Tests for normality
Descriptives
Statistic Std. Error
DAt/At-1 Mean -,084515010841 ,0037744069474
95% Confidence Interval for
Mean
Lower Bound -,091937948246
Upper Bound -,077092073437
5% Trimmed Mean -,083088837493
Median -,082886614000
Variance ,005
Std. Deviation ,0713153192949
Minimum -,3438058800
Maximum ,1471923700
Range ,4909982500
Interquartile Range ,0809065190
Skewness -,299 ,129
Kurtosis 1,261 ,257Table 3 – Normality Test Descriptive
Tests of Normality
Kolmogorov-Smirnova Shapiro-Wilk
Statistic df Sig. Statistic df Sig.
DAt/At-1 ,058 357 ,006 ,982 357 ,000
a. Lilliefors Significance CorrectionTable 4 – Tests of Normality
76
Boxplot
77
Appendix 3: Estimating Discretionary Accruals
Results from estimating the coefficients b0, b1, b2 and b3 in the second step of measuring
discretionary accruals:
Model Summary
Model R R Square
Adjusted R
Square
Std. Error of the
Estimate
1 ,434a ,188 ,179 ,1147137729125
a. Predictors: (Constant), ROAt-1/At-1, (REVt-RECt)/At-1, PPEt/At-1, 1/At-1
Table 5 – BETAs Model Summary
ANOVAb
Model Sum of Squares df Mean Square F Sig.
1 Regression 1,104 4 ,276 20,969 ,000a
Residual 4,764 362 ,013
Total 5,867 366
a. Predictors: (Constant), ROAt-1/At-1, (REVt-RECt)/At-1, PPEt/At-1, 1/At-1
b. Dependent Variable: TAt/At-1
Table 6 – BETAs ANOVA
Coefficientsa
Model
Unstandardized
Coefficients
Standardized
Coefficients
t Sig.B Std. Error Beta
1 (Constant) -,062 ,013 -4,699 ,000
1/At-1 33,842 27,338 ,081 1,238 ,217
(REVt-RECt)/At-1 ,161 ,021 ,399 7,538 ,000
PPEt/At-1 ,017 ,015 ,062 1,137 ,256
ROAt-1/At-1 -714,490 408,728 -,112 -1,748 ,081
a. Dependent Variable: TAt/At-1
Table 7 – BETAs Coefficients
78
Homoscedasticity test:
Multicollinearity tests:
Model
Collinearity Statistics
Tolerance VIF
1 (Constant)
(REVt-RECt)/At-1 ,804 1,244
PPEt/At-1 ,799 1,251
ROAt-1/At-1 ,981 1,019
a. Dependent Variable: 1/At-1
Model
Collinearity Statistics
Tolerance VIF
1 (Constant)
ROAt-1/At-1 ,548 1,824
1/At-1 ,549 1,821
(REVt-RECt)/At-1 ,997 1,003
a. Dependent Variable: PPEt/At-1
79
Model
Collinearity Statistics
Tolerance VIF
1 (Constant)
PPEt/At-1 ,957 1,045
ROAt-1/At-1 ,547 1,827
1/At-1 ,530 1,887
a. Dependent Variable: (REVt-RECt)/At-1
Model
Collinearity Statistics
Tolerance VIF
1 (Constant)
1/At-1 ,944 1,059
(REVt-RECt)/At-1 ,799 1,252
PPEt/At-1 ,767 1,303
a. Dependent Variable: ROAt-1/At-1
Appendix 4: Testing the Hypotheses
Appendix 4.1: Hypothesis 1 results
Model Summary
Model R R Square Adjusted R Square Std. Error of the Estimate
1 ,223a ,050 ,036 ,0700055318496
a. Predictors: (Constant), ctr_PriorLoss, ctr_size, ctr_growth, audit tenure, ctr_leverageTable 8 – Model Summary
ANOVAb
Model Sum of Squares df Mean Square F Sig.
1 Regression ,090 5 ,018 3,689 ,003a
Residual 1,720 351 ,005
Total 1,811 356
a. Predictors: (Constant), ctr_PriorLoss, ctr_size, ctr_growth, audit tenure, ctr_leverage
b. Dependent Variable: DAt/At-1
Table 9 – ANOVA
Coefficientsa
Model
Unstandardized Coefficients
Standardized
Coefficients
t Sig.B Std. Error Beta
1 (Constant) -,010 ,032 -,311 ,756
Audit tenure ,004 ,002 ,123 2,330 ,020
ctr_leverage -,039 ,027 -,075 -1,415 ,158
ctr_size -,008 ,003 -,125 -2,374 ,018
ctr_growth ,032 ,014 ,118 2,231 ,026
ctr_PriorLoss -,018 ,013 -,074 -1,406 ,161
a. Dependent Variable: DAt/At-1
Table 10 – Coefficients
80
Homoscedasticity test:
Multicollinearity tests:
Coefficientsa
Model
Collinearity Statistics
Tolerance VIF
1 ctr_size ,984 1,017
ctr_growth ,985 1,016
ctr_leverage ,962 1,039
ctr_PriorLoss ,976 1,025
a. Dependent Variable: audit tenure
Coefficientsa
Model
Collinearity Statistics
Tolerance VIF
1 ctr_leverage ,969 1,032
ctr_PriorLoss ,974 1,027
Audit tenure ,991 1,009
ctr_size ,984 1,017
a. Dependent Variable: ctr_growth
Coefficientsa
Model
Collinearity Statistics
Tolerance VIF
1 ctr_PriorLoss ,978 1,022
Audit tenure ,967 1,034
ctr_size ,997 1,003
ctr_growth ,968 1,033
a. Dependent Variable: ctr_leverage
81
Coefficientsa
Model
Collinearity Statistics
Tolerance VIF
1 ctr_growth ,960 1,042
ctr_leverage ,974 1,027
ctr_PriorLoss ,967 1,034
Audit tenure ,966 1,035
a. Dependent Variable: ctr_size
Coefficientsa
Model
Collinearity Statistics
Tolerance VIF
1 Audit tenure ,976 1,025
ctr_size ,985 1,015
ctr_growth ,968 1,033
ctr_leverage ,974 1,027
a. Dependent Variable: ctr_PriorLoss