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Journal of Accounting and Economics 47 (2009) 265287

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Journal of Accounting and Economics

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Earnings quality: Some evidence on the role of auditor tenure and auditors industry expertise$
Ferdinand A. Gul a,, Simon Yu Kit Fung a,1, Bikki Jaggi a,b,2
a b

School of Accounting and Finance, The Hong Kong Polytechnic University, Hung Hom, Kowloon, Hong Kong School of Business, Rutgers University, Levin Building, Piscataway, NJ 08850, USA

a r t i c l e in fo
Article history: Received 14 September 2007 Received in revised form 4 March 2009 Accepted 4 March 2009 Available online 17 March 2009 JEL classication: M43 M49 Keywords: Auditor tenure Auditor industry specialization Low balling Earnings quality

abstract
Prior studies suggest that auditors with short tenure are associated with lower earnings quality because of the lack of client-specic knowledge and/or low balling. In this study, we examine whether industry specialization of auditors and low balling affect the association between auditor tenure and earnings quality. We nd that the association between shorter auditor tenure and lower earnings quality is weaker for rms audited by industry specialists compared to non-specialists. In addition, we do not nd results consistent with the low balling explanation. & 2009 Elsevier B.V. All rights reserved.

1. Introduction Recent research shows that auditors with shorter tenure are associated with lower earnings quality than auditors with longer tenure (e.g. Johnson et al., 2002; Myers et al., 2003; Ghosh and Moon, 2005). Auditor tenure is dened as the number of years an auditor is retained by the rm (Myers et al., 2003). Three different explanations have been provided for this relationship. The rst is based on the argument that short-tenured auditors lack client-specic knowledge that is necessary to conduct a high-quality audit. In addition, the accounting profession argues that short tenure may involve higher risk for audit failures, because incoming auditors with insufcient client-specic knowledge will have to rely more heavily on the estimates and representations made by client rms (e.g. PricewaterhouseCoopers, 2002; Gul et al., 2007). The second is based on low balling, whereby auditors charge lower audit fees to obtain and retain new clients and then expect to recoup losses in later years of the audit engagements (DeAngelo, 1981). This argument suggests that auditors with short tenure may be more lax in the early years of the auditorclient relationship so that they can retain the job long
$ We thank an anonymous reviewer, Jerry Zimmerman (the editor), Mark Bliss, Shimin Chen, Peter Cheng, Richard Chung, Carol Dee, Jun Du, Kimberly Dunn, Jere Francis, Stephen Gong, Ira Horowitz, Yuan Huang, Kam Wah Lai, Chung-kin Min, Al Nagy, Bin Srinidhi, Nancy Su, Joanna Ho, Suresh Radhakrishnan, Cheong H. Yi, workshop participants in The Hong Kong Polytechnic University, 2007 Journal of Contemporary Accounting and Economics Symposium, 2007 AAA Auditing Midyear Conference and other individuals for their helpful comments. Corresponding author. Tel.: +852 2766 7771; fax: +852 2365 9303. E-mail addresses: afgul@inet.polyu.edu.hk (F.A. Gul), afsf@inet.polyu.edu.hk (S.Y.K. Fung), Jaggi@rbsmail.rutgers.edu (B. Jaggi). 1 Tel.: +852 2766 4246; fax: +852 2330 9845. 2 Tel.: +732 445 3539; fax: +732 445 3201.

0165-4101/$ - see front matter & 2009 Elsevier B.V. All rights reserved. doi:10.1016/j.jacceco.2009.03.001

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enough to recoup the initial losses, resulting in lower quality audits and lower quality earnings (Gul et al., 2007). The third is based on the argument that rms with higher quality earnings are more likely to retain the incumbent (high-quality) auditors, or high-quality auditors are more likely to drop risky clients that have lower quality earnings, who will then move to lower quality auditors. In this study, we rst examine whether the positive relation between auditor tenure and earnings quality, as documented in prior research, is weaker for rms audited by industry specialists. Second, we evaluate whether the observed lower earnings quality in the early years of the auditorclient relationship is consistent with the low balling argument. Our paper is motivated by two primary considerations. First, both the nancial press and policy makers remain concerned about alleged earnings management in US companies (e.g. Levitt, 2007; Karpoff et al., 2008). Related to these concerns is the fact that academics, practitioners, and policy makers raise doubts about the quality of auditors with shorter tenure and its implications for earnings quality (e.g. Arel et al., 2005; Dunham, 2002; Geiger and Raghunandan, 2002; PricewaterhouseCoopers, 2002). The importance of this research question is further exemplied by the fact that highquality accounting information is central to the efcient allocation of scarce capital resources in the market (e.g. Foster and Johnson, 2001). It would be useful for investors and other interested parties to be aware that situations may exist in which the documented association between lower quality of earnings and shorter auditor tenure is weaker. One such situation is the presence of an industry-specialist auditor.3 Second, while there is ample evidence to support the short tenure/ low-quality earnings relation, there has been little attempt to examine whether this relation is related to low balling or lack of client-specic knowledge. This paper attempts to provide some understanding of this issue. A maintained assumption in the linkage between auditors industry specialization and the shorter auditor tenure/lower earnings quality association is based on prior studies, which show that auditors industry specialization is associated with higher earnings quality (e.g. Balsam et al., 2003; Krishnan, 2003). Industry specialization is dened in terms of the auditors market share (see Francis et al., 2005a). An auditor is considered a specialist in an industry if the audit rm has the largest share of the industrys total assets (Mayhew and Wilkins, 2003). Based on this assumption, we expect that the association between lower earnings quality and shorter auditor tenure would be weaker if the auditors are also industry specialists, ceteris paribus. In our main tests, we use discretionary accruals as a proxy for earnings quality, which are estimated based on a model suggested by Ball and Shivakumar (2006). In addition, as sensitivity tests, we use other discretionary accruals models and the earnings benchmark tests. Based on a sample of observations from 1993 to 2004, we show that earnings quality is lower when auditor tenure is short. Additionally, we nd that the positive association between earnings quality and auditor tenure is signicantly weaker for rms that are audited by industry specialists. However, these results have to be viewed with some caution since the data used in the study may be largely drawn from a presumably optimal matching between auditors and clients i.e. the client retains the best auditor, and the auditor keeps the best clients. We address this limitation by conducting tests of endogeneity. In a separate set of tests, we examine whether the higher discretionary accruals in the earlier years of auditorclient relationship (less than 4 years) can be explained by low balling. Based on a sample of rms from 2000 to 2004, we identify low balling rms as the rms with short auditor tenure (less than 4 years) and the auditor charges abnormally low audit fees (when audit fees are one standard deviation below the predicted audit fees based on an audit fees model). Results show that there is no signicant association between low balling and lower earnings quality. To address the potential endogeneity problems in our main tests associated with hiring of short-tenured versus longtenured auditors, or specialists versus non-specialists (self-selection bias), we use a two-stage least-squares (2SLS) estimation procedures. The results of these tests are similar to our main ndings. Our main test results are also robust to other discretionary accruals models such as the accruals quality measure developed by Francis et al. (2005b), the Jones discretionary accruals model (Jones, 1991), or the performance-adjusted model (e.g. Ashbaugh et al., 2003; Kothari et al., 2005). In addition, similar results are obtained when we use meeting or beating the earnings benchmarks as an alternative measure of earnings quality. Overall, our results suggest that industry specialization is likely to reduce the association between shorter auditor tenure and lower earnings quality. Our results contribute to the auditing literature in the following ways. First, our ndings add to the literature on the linkage between industry specialization and audit quality (Gramling and Stone, 2001; Balsam et al., 2003; Dunn and Mayhew, 2004) by showing that industry specialization has a role to play in the early years of auditorclient relationship. The results also suggest that the evidence in prior studies linking short auditor tenure with poor earnings quality (e.g. Myers et al., 2003; Johnson et al., 2002; Carcello and Nagy, 2004) is likely to apply more to rms audited by industry nonspecialists. These results suggest that the documented evidence linking short tenure to poor earnings quality may not be due to shorter tenure per se, but rather it may be due to the auditors unfamiliarity with the clients business that could affect the auditors ability to detect misrepresentations and/or misreporting. It should, however, be noted that our results should not be interpreted to mean that all industry specialists or the use of specialists services will always improve earnings quality. Second, this study represents the rst attempt to empirically distinguish the low balling argument from the lack of client-specic knowledge argument.

3 It should be noted that investigation of this type is a joint test of (1) the association between auditor tenure, industry specialization and earnings quality, and (2) the adequacy of our empirical model in controlling for non-auditor sources of earnings quality.

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The remainder of the paper is organized as follows. In Section 2, we discuss the background and research questions for the study. Section 3 contains discussion on sample selection and research design. Results are discussed in Section 4, and the conclusion is contained in Section 5. 2. Background and research questions 2.1. Audit quality and earnings quality The assumption in this study that audit quality is positively linked to earnings quality is not new and has been extensively documented in the accounting and auditing literature. Several prior studies document an association between measures of higher quality auditors (such as auditor size or industry expertise) and higher quality of nancial reporting (e.g. Becker et al., 1998; Johnson et al., 2002; Krishnan, 2003; Balsam et al., 2003; Myers et al., 2003; Ghosh and Moon, 2005). This linkage is based on the argument that high-quality auditors, as a result of more effective monitoring, are more likely to detect questionable accounting practices and misrepresentations by management than low-quality auditors. If managers are unwilling to address the auditors concerns with regard to questionable accounting practices and misrepresentations, high-quality auditors are more likely to issue qualied audit reports. In this sense, the quality of nancial reporting (earnings quality) may be viewed as a joint product of managerial and auditor efforts. 2.2. Auditor tenure and earnings quality Recent studies in the auditing literature suggest that auditors with longer tenure are associated with higher earnings quality (Geiger and Raghunandan, 2002; Gul et al., 2007). Johnson et al. (2002), for example, document higher unexpected accruals when auditor tenure is short (23 years) than when it is medium (48 years). Moreover, they nd no evidence that a longer auditorclient relationship (i.e. 9 years or more) is associated with lower unexpected accruals compared to the medium auditorclient relationship. Myers et al. (2003) nd that a longer auditorclient relationship is associated with a lower dispersion in the distributions of discretionary and current accruals, and there are greater constraints on both income-increasing and income-decreasing discretionary accruals. Consistent with Myers et al. (2003), Ghosh and Moon (2005) provide evidence that rms with longer auditor tenure are associated with stronger earnings response coefcients, suggesting that investors perceive earnings quality of rms with longer auditor tenure to be better than the earnings quality of rms with shorter auditor tenure. The above ndings are consistent with learning theory in psychology (Glaser and Chi, 1988; Glaser and Bassok, 1989; Lapre et al., 2000), which suggests that it takes time for auditors to develop client-specic knowledge to perform an effective audit. For example, an auditor conducting an audit for the same client over a number of years learns successively about critical accounting issues that may require particular attention. However, there are other alternative explanations. One interpretation of these results is that auditors in the early years of the auditorclient relationship are less independent as a result of low balling. Another interpretation is that clients may switch auditors or auditors may drop clients with poor quality earnings. For example, it is possible that rms with higher earnings quality have a tendency to retain the same auditor. This interpretation is consistent with the auditor-switching and opinion-shopping literature (e.g. DeFond and Subramanyam, 1998; Krishnan, 1994; Lennox, 2000), which suggests that rms switch auditors after receiving a qualied report (in some cases as a result of poor earnings quality). Alternatively, high-quality auditors may drop risky clients (in particular clients with large unexpected accruals or lower earnings quality) in the rst few years of their audit engagements. 2.3. Auditor industry specialization and earnings quality In addition to auditor tenure, auditors industry specialization is considered to be another proxy for audit quality. Several prior studies show that client rms with industry specialists are associated with higher quality of nancial reporting (e.g. Balsam et al., 2003; Krishnan, 2003). These ndings are consistent with the theory that auditors specialize in various industries to achieve product differentiation and provide higher quality audits (Simunic and Stein, 1987; Dunn and Mayhew, 2004). Higher quality of audits by industry specialists is also attributed to the fact that they invest heavily in technologies, physical facilities, personnel, and organizational control systems that enable them to detect irregularities and misrepresentations more easily (Simunic and Stein, 1987). Their ability to provide higher quality audits comes from their experience in serving other clients in the same industry and learning and sharing best practices across the industry (Maletta and Wright, 1996; Dunn and Mayhew, 2004). Similarly, PricewaterhouseCoopers (2002) argue that audit quality depends on numerous factors including an auditors knowledge and understanding of the company being audited and the industry in which it operates. These arguments thus suggest that auditors with industry expertise are more likely to detect misrepresentations and irregularities than auditors without industry expertise, especially in the early years of the audit assignment. The linkage is based on the assumption that industry-specialist auditors have the industry expertise that results in better understanding of the clients business (e.g. Kwon, 1996). There is, however, an alternative explanation for this association. It could be argued that rms with higher earnings quality may hire industry specialists, and thus the

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observed positive association between earnings quality and industry specialization may be due to self-selection of specialist auditors. We address this issue in our sensitivity tests. 2.4. Auditor tenure, industry specialization, and earnings quality In this study, we integrate these two streams of research on auditor tenure and auditor industry specialization to examine whether auditors industry specialization has an impact on the association between auditor tenure and earnings quality. Though evidence suggests that client-specic knowledge plays an important role in conducting an effective audit, it may be argued that many audit-related issues are industry-specic and have unique industry features e.g. forward sales contracts, off balance sheet nancing arrangements, accounting systems, tax rules or specialized reporting requirements in certain industries. Consequently, industry expertise is also likely to play a role in improving audit quality in terms of auditor competence, in addition to the general knowledge base required for all audits (e.g. Shockley and Holt, 1983; Craswell et al., 1995). The linkage between auditor tenure, specialization and earnings quality is thus based on the assumption that auditors ability to perform an audit effectively and efciently will depend on their expertise in the clients industry as well as on their client-specic knowledge. Auditors expertise in the clients industry is therefore likely to be benecial in a new auditorclient relationship when the auditor lacks client-specic knowledge. 2.5. Low balling Since low balling has been identied as one of the factors that could be linked to the lower quality of earnings for auditors in the rst few years of an audit engagement (see, for example, DeAngelo, 1981), we also conduct tests to assess if our results are consistent with predictions of the low balling argument. We construct a sample of low balling rms and evaluate their association with earnings quality. The results of this evaluation will indicate whether low balling is likely to contribute to the linkage between shorter auditor tenure and lower earnings quality, ceteris paribus. 3. Research design 3.1. Sample This study is based on a sample of rms from 1993 to 2004. All rms with sufcient data on the Compustat annual industrial and research les for estimation of accruals are included in the initial sample.4 We include only rms that are audited by Big 6/5/4 auditors5 (hereafter referred to as Big N auditors) because the focus of our research is on industry specialization of auditors, which is generally identied within the big accounting rms (e.g. Francis et al., 2005a; Johnson et al., 2002).6 Firms with mergers and acquisitions (M&A) are dropped from the sample because accruals in rms with mergers and acquisitions tend to be larger for reasons unrelated to earnings management (Ashbaugh et al., 2003).7 Our nal sample consists of 32,777 rm-year observations. 3.2. Calculation of discretionary accruals Despite the extensive use of discretionary accruals as a measure of earnings quality (e.g. Myers et al., 2003; Ashbaugh et al., 2003; Balsam et al., 2003; Johnson et al., 2002), there is still little evidence documenting which discretionary accruals model is superior or more appropriate. While we use different models of discretionary accruals in our sensitivity tests, main tests are based on the discretionary accruals model suggested by Ball and Shivakumar (2006). We modify this model slightly to include the components of growth and cash ows. We use the following model for each of the two-digit SIC industry groups8 to estimate discretionary accruals, which are given by the residual term (et). ACC t a1 a2 CFOt a3 CFOt1 a4 CFOt1 a5 DRevt a6 PPEt a7 ROAt1 a8 DCFOt a9 DumDCFOt a10 DCFOt DumDCFOt t (1)

4 In an additional test, we follow Myers et al., 2003) in requiring at least 6 years of prior data to ensure that any abnormal accruals behavior associated with start-up rms (Teoh et al., 1998a, 1998b) is not attributed to short auditor tenure. In another sensitivity test, we also omit rms for which the auditorclient relationship lasted for 5 years or less in our sample (e.g. Myers et al., 2003). These additional screening procedures reduce the sample size, but our main results (untabulated) remain unchanged. 5 Big 6 auditors include Arthur Andersen, Coopers and Lybrand, Deloitte Touche Tohmatsu, Ernst and Young, KPMG and PricewaterhouseCoopers. 6 Because auditor industry expertise is unobservable, prior studies rely on the auditors relative size in the industry as a measure of industry specialization, based on the assumption that the auditors industry expertise increases with their market shares and investment (e.g. Craswell et al., 1995; Hogan and Jeter, 1999; Francis et al., 2005a). Since Big N auditors are substantially larger in size than other audit rms in almost all industries, using industry size as a measure of auditor specialization will effectively render most non-Big N auditors non-specialists, even if these non-Big N auditors were indeed specialists in some industries. As a result, industry size would be a better measure of an auditors industry expertise (e.g. Francis et al., 2005a) within big accounting rms. We obtain similar results (untabulated) by including non-Big N rms in the sample in a sensitivity test. 7 In a sensitivity test we include M&A rms in our sample and add an indicator for M&A in our multivariate analyses. Results (untabulated) show that the coefcient on M&A indicator is signicantly positive, and our main results still hold. 8 There should be at least 20 rms in each industry group for each year.

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where ACC is the earnings before extraordinary items (Compustat annual data item 123) cash ow from operations (Compustat annual data item 308); CFO is the cash ow from operations for periods t1, t and t+1; DRev is the change in net sales revenue (Compustat annual data item 12); and PPE is the property, plant, and equipment-net (Compustat annual data item 8). ROAt1 is the one-period lag ROA and DumDCFO is the dummy variable, 1 when there is a negative change in the operating cash ows, 0 otherwise. All variables are scaled by average total assets, calculated as the average of beginning of year and end of year total assets. 3.3. Auditor tenure and auditor specialization Auditor tenure is calculated based on the available data from Compustat, and is dened as the number of years an auditor is retained by the rm. In the case of change in the audit rms name as a result of audit rm mergers, the incumbent auditorclient relationship remains unchanged. A Big N audit rms industry specialization is measured based on its share of clients total assets in the two-digit SIC industry group, and industry expertise is assumed when the audit rms market share is the highest within the industry group (Hogan and Jeter, 1999; Krishnan, 2005).9 Operationally, we rank Big N auditors based on their percentage of total assets audited in the industry, and the audit rm capturing the largest market share (of total assets) is identied as a specialist in that industry. 3.4. Construction of low balling sub-sample In order to assess if low balling is a viable explanation for the lower earnings quality of rms with short auditor tenure, we construct a sub-sample of rms likely to be associated with low balling. We dene low balling as a condition when (1) auditors charge abnormally low audit fees and (2) auditor tenure is short. We estimate the normal level of audit fees based on an audit fee model (e.g. Gul and Tsui, 1998; Francis et al., 2005a),10 using observations with auditor tenure of more than 3 years. Audit fees are considered to be abnormally low when they are one standard deviation below the projected audit fees.11 Tenure is considered to be short if it is less than or equal to 3 years (e.g. Johnson et al., 2002; Carcello and Nagy, 2004). We include rms with auditor tenure less than or equal to 3 years during the 20002004 period for which audit fee data is publicly available.12 The indicator variable LowBall is coded as one if the actual audit fee paid by the rm is one standard deviation lower than the projected audit fee, and zero otherwise. 3.5. Regression model Our main tests are conducted based on the absolute value of discretionary accruals (ABSTDA) under the premise that upward as well as downward adjustments of reported earnings are considered as earnings management that lowers the quality of reported earnings (Myers et al., 2003). The following regression model is used to estimate the association between absolute discretionary accruals and auditor tenure: ABSTDA a b1 Tenure b2 Age b3 Size b4 Size2 b5 Size3 b6 IndGrow b7 Grow b8 CFO bj IndustryDum bk YearDum  (2)

where ABSTDA is the absolute value of discretionary accruals scaled by average total assets; Tenure is the log of auditor tenure, measured as the number of consecutive years that the rm has retained the auditor; Age is the log of rm age, measured as the number of years that the rm appeared in Compustat since 1950;13 Size, Size2 & Size3 are the market value PN P of equity (in 10 billions) to the power one, two and three; IndGrow is the N i1 Salesi;t = i1 Salesi;t1 by Fama and Frenchs (1997) 48 industry groups;14 Grow is the rm-specic sales growth, measured as Salest/Salest1; CFO is the rms cash ow from operations divided by average total assets; IndustryDum are the dummies for Fama and Frenchs (1997) 48 industry groups; and YearDum are the dummies for scal year. Since absolute values of discretionary accruals used as a dependent variable are truncated at zero, a truncated regression approach is adopted to arrive at unbiased estimates of coefcients in the model.15
9 In an additional test, we use client sales as the basis to calculate market share captured by an auditor. Further, we measure industry expertise based on city-level industry market shares and both national- and city-level industry market shares as suggested in Francis et al. (1999, 2005a), The results based on these tests (untabulated) are qualitatively similar to the results reported in the tables. 10 The audit fee model used is discussed in Appendix A of this paper. 11 Alternatively, we dene abnormally low audit fees to be negative abnormal fees when they are in the lowest 25% of the distribution. We obtain qualitatively similar results (untabulated) using this alternative denition. 12 We also conduct sensitivity tests by splitting the sample to groups based on the pre- and post-SOX periods, and obtain qualitatively similar results (discussed in Section 4.5.4). 13 Alternatively, we use the number of years the rm has existed on the CRSP database to measure Age; the results (untabulated) are qualitatively similar to our main ndings. 14 In a sensitivity test, we compute IndGrow and include industry dummies based on two-digit SIC codes; the results (untabulated) are qualitatively similar to our main ndings. 15 See Myers et al. (2003), Greene (2000, pp. 682690) and Maddala (1977, pp. 269273) for further discussion on the truncated regression approach.

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In order to control for factors affecting discretionary accruals that are unrelated to auditor tenure, we include several control variables (see also Myers et al., 2003). We use rm age (Age) to control for the difference in discretionary accruals of rms with different life cycles (Anthony and Ramesh, 1992) and market value of equity16 (Size) to control for the differences in the accrual behaviour of managers of large and small rms. While some researchers argue that larger rms have more stable discretionary accruals (Dechow and Dichev, 2002), others document that the magnitude of discretionary accruals reported by larger rms is systematically lower (e.g. Ashbaugh et al., 2003). Because Size is correlated strongly with both ABSTDA and other rm characteristics, we use a third-degree polynomial (Size, Size2 & Size3) of market value to capture the non-linear size effects. Because growth rms in an industry may report systematically different levels of accruals (Myers et al., 2003), the growth effect is controlled by using growth in industry sales (IndGrow). Firm-specic growth in sales (Grow) is also included in order to capture the possible difference in the accruals behaviour between rms with high and low growth that is unrelated to earnings management.17 In addition, we include CFO in the model to take into account the negative association between accruals and cash ows as documented in prior studies (e.g. Dechow, 1994). Industry and year xed effects are also included in the model. All continuous variables are winsorized at three standard deviations. We expect the coefcient for Tenure to be negative, suggesting shorter tenure is associated with higher discretionary accruals, i.e. lower earnings quality. Additionally, we expect this association to be signicantly weaker for rms audited by industry specialists. We conduct tests based on both specialist and non-specialist sub-samples, as well as on the full sample with an interaction term between tenure and specialists. 4. Empirical results 4.1. Descriptive statistics Table 1 presents descriptive statistics for discretionary accruals and other variables used in the study. Panel A shows that the means of absolute discretionary accruals (ABSTDA) are 3.6% and 4.0% for specialists and nonspecialists respectively, indicating that the magnitude of discretionary accruals is lower for the specialist sub-group. Though the means of absolute discretionary accruals are consistent with prior literature (e.g. Balsam et al., 2003), their high magnitudes (4% of total assets) may be due to problems associated with the specication of discretionary accruals models (e.g. Dopuch et al., 2005; Ball and Shivakumar 2006).18 Univariate tests show that the mean of Tenure(log) is shorter for the specialist sub-sample compared to the non-specialist sub-sample. In addition, rms audited by specialists are in general older, larger in size, and have higher cash ows. The correlations among variables used in the regression, as reported in Panel B of Table 1, show that tenure is negatively associated with absolute discretionary accruals and similarly rm age, rm size, industry growth, rm-specic growth and cash ows are negatively correlated with discretionary accruals. 4.2. Auditor tenure and ABSTDA We rst test the association between auditor tenure and absolute value of discretionary accruals (ABSTDA) for the total sample. The results based on the total sample, reported in the All column in Table 2, show that the coefcient for Tenure is signicantly negative. This nding is consistent with prior research (e.g. Myers et al., 2003), and indicates that longer auditor tenure is associated with lower absolute discretionary accruals, suggesting higher quality of reported earnings. Results on the control variables show that while the coefcient for industry growth is insignicant, rm-specic growth is positively associated with ABSTDA, consistent with evidence in prior studies (e.g. Ashbaugh et al., 2003). Similar to Myers et al. (2003), our results show that rm age is negatively associated with discretionary accruals. The results on cash ows are also consistent with other prior studies (e.g. Dechow, 1994). It is also shown that the relationship between size and discretionary accruals is non-linear.19
16 Other measures of size, such as sales or total assets, are used in sensitivity analyses; the results (untabulated) are qualitatively similar to our main results. In addition, we conduct tests on small and large client rms separately based on median size. The test results (untabulated) are similar to the main results. 17 Recent studies (e.g. Hribar and Nichols, 2007) suggest that operating volatility is an additional determinant of absolute discretionary accruals. As additional tests, we include various measures of operating volatility (standard deviation of operating cash ows, standard deviation of sales and standard deviation of earnings over the current and prior four years) and re-estimate all our models. The results (untabulated) are qualitatively similar to our main ndings. 18 Caution is required in drawing inferences based on results using discretionary accruals with such high magnitudes. To address this potential weakness, we conducted additional tests by using the likelihood of meeting or beating earnings benchmarks and the results are qualitatively similar (discussed in Section 4.6.3). 19 We also conduct a number of tests to address some econometric concerns. For example, we compute clustered standard errors, as suggested by Petersen (2009) to address the potential problems of non-independence of panel observations. We also estimate average coefcients of annual regressions over the 12 years for all our tests using the FamaMacBeth procedure. These tests provide qualitatively similar results. We also obtain similar results in other sensitivity tests, such as the inclusion of rm-level xed effects, the use of ordinary least-squares regression and the use of White-corrected statistics (1980).

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Table 1 Descriptive statistics. Panel A: Variables in main regressions Variable Non-specialists (N 24,433) Mean ABSTDA Tenure (raw) Tenure (log) Age (raw) Age (log) Size Size2 Size3 IndGrow Grow CFO 4.0% 8.016 1.910 10.474 2.176 0.180 0.941 14.956 1.093 0.479 0.021 Median 2.6% 7.000 1.946 9.000 2.197 0.015 0.000 0.000 1.080 1.074 0.067 SD 4.477 5.020 0.588 7.481 0.569 0.953 19.349 660.414 0.125 14.055 0.202 Specialists (N 8344) Mean 3.6% 8.072 1.876 11.370 2.214 0.301 1.671 22.876 1.093 0.343 0.035 Median 2.3% 7.000 1.946 9.000 2.197 0.023 0.001 0.000 1.081 1.075 0.072 SD 4.046 5.840 0.645 9.422 0.623 1.257 20.989 501.326 0.137 13.772 0.178 Mean differences t-Stat 7.43*** 0.79 4.35*** 7.88*** 4.96*** 8.04*** 2.80*** 1.14 0.07 0.77 5.77***

Panel B: Pairwise correlations among variables used in regressions Variable ABSTDA Tenure Age Size Size2 Size3 IndGrow Grow CFO Tenure 0.10 (0.00) Age 0.12 (0.00) 0.64 (0.00) Size 0.08 (0.00) 0.11 (0.00) 0.13 (0.00) Size2 0.02 (0.00) 0.05 (0.00) 0.05 (0.00) 0.81 (0.00) Size3 0.01 (0.24) 0.03 (0.00) 0.02 (0.00) 0.60 (0.00) 0.93 (0.00) IndGrow 0.02 (0.00) 0.03 (0.00) 0.04 (0.00) 0.00 (0.58) 0.00 (0.93) 0.00 (0.64) Grow 0.03 (0.00) 0.04 (0.00) 0.04 (0.00) 0.02 (0.00) 0.01 (0.25) 0.00 (0.58) 0.00 (0.69) CFO 0.26 (0.00) 0.15 (0.00) 0.19 (0.00) 0.11 (0.00) 0.04 (0.00) 0.02 (0.00) 0.04 (0.00) 0.21 (0.00) Specialist 0.04 (0.00) 0.03 (0.00) 0.03 (0.00) 0.05 (0.00) 0.02 (0.00) 0.01 (0.32) 0.00 (0.94) 0.00 (0.44) 0.03 (0.00)

*, ** and *** represent signicance at po0.10,o0.05 and o0.01, respectively. p-Values (two-tailed) are reported in parentheses. Variable denitions: ABSTDA absolute value of discretionary accruals scaled by average total assets (based on Ball and Shivakumar, 2006); Tenure log of auditor tenure, measured as the number of consecutive years that the rm has retained the auditor; Age log of rm age, measured as the number of years that the rm appeared in Compustat since 1950; Size, Size2 & Size3 market value of equity (in 10 billions) to the power one, two and three; P PN IndGrow N i1 Salesi;t = i1 Salesi;t 1 by Fama and Frenchs (1997) 48 industry groups; Grow irm-specic sales growth, measured as Salest/Salest1; CFO irms cash ow from operations divided by average total assets; and Specialist dummy variable, equals 1 for rms audited by auditor whose market shares is highest in terms of clients total asset for each industry group, 0 otherwise.

4.3. Auditor tenure, auditor industry specialization and ABSTDA In order to evaluate the role of auditor industry specialists on the association between discretionary accruals and auditor tenure, we conduct two tests. First, we divide the total sample into auditor industry specialists and auditor nonspecialists sub-samples and conduct tests separately for each of the sub-samples. Out of the total sample, 24,433 rm-year observations are audited by non-specialists and 8344 rm-year observations by industry specialists. The results on the subsamples, as reported in Table 2, show that the Tenure coefcient continues to be negative and signicant for the nonspecialist sub-sample, suggesting that discretionary accruals are higher when auditor tenure is short and rms are audited by non-specialists (t-stat 6.2). The Tenure coefcient for the specialist sub-sample is, however, statistically insignicant based on the two-tailed test (t-stat 1.6), suggesting that shorter tenure is not associated with higher discretionary accruals when rms are audited by industry specialists. Although the coefcient is statistically signicant at 10% level with a one-tailed test, the magnitude of coefcient for the non-specialist sub-sample (0.382) is signicantly larger than that for the specialist sub-sample (0.14) (F-value 21.2). Consistent with our expectation, this nding suggests that the

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Table 2 Association between ABSTDA and auditor tenure, partitioned by auditor industry specialization. Dependent variable: ABSTDA All Coeff. Intercept Tenure Age Size Size2 Size3 IndGrow Grow CFO YearDum IndustryDum Pseudo-R2 N Diff in coeff. F-value p-Value 2.497 0.299 0.209 0.611 0.051 0.001 0.085 0.005 4.730 Yes Yes 0.135 32,777 t-Stat 4.2 5.9 3.7 10.3 7.5 5.7 0.4 3.2 36.1 p-Value (0.00) (0.00) (0.00) (0.00) (0.00) (0.00) (0.65) (0.00) (0.00) Yes Yes 0.131 24,433 21.2 (0.00) Non-specialists Coeff. 2.097 0.382 0.142 0.726 0.064 0.001 0.047 0.006 4.597 t-Stat 2.7 6.2 2.1 9.3 7.2 5.9 0.2 2.8 30.4 p-Value (0.01) (0.00) (0.04) (0.00) (0.00) (0.00) (0.84) (0.00) (0.00) Specialists Coeff. 3.337 0.140 0.357 0.486 0.045 0.001 0.423 0.004 5.051 Yes Yes 0.151 8344 t-Stat 3.7 1.6 3.6 4.6 2.9 2.2 1.3 1.4 19.0 p-Value (0.00) (0.11) (0.00) (0.00) (0.00) (0.03) (0.19) (0.16) (0.00)

Estimations are based on truncated regression approach. t-Values are reported in italics. p-Values (two-tailed) are reported in parentheses. Variable denitions: ABSTDA bsolute value of discretionary accruals scaled by average total assets (based on Ball and Shivakumar, 2006); Tenure og of auditor tenure, measured as the number of consecutive years that the rm has retained the auditor; Age log of rm age, measured as the number of years that the rm appeared in Compustat since 1950; Size, Size2 & Size3 market value of equity (in 10 billions) to the power one, two and three; PN P IndGrow N i1 Salesi;t = i1 Salesi;t1 by Fama and Frenchs (1997) 48 industry groups; Grow rm-specic sales growth, measured as Salest/Salest1; CFO rms cash ow from operations divided by average total assets; Specialist dummy variable, equals 1 for rms audited by auditor whose market shares is highest in terms of clients total asset for each industry group, 0 otherwise; YearDum dummies for scal years; IndustryDum dummies for Fama and Frenchs (1997) 48 industry groups.

association between auditor tenure and discretionary accruals is signicantly weaker for rms audited by industry specialists. Second, we conduct a test on the total sample by including the Specialist variable and an interaction term between Specialist and Tenure.20 To allow the coefcients of the control variables to vary between specialists and non-specialists, we also include interaction terms between Specialist and all control variables, including the industry and year xed effect variables. The results reported in Table 3 show that the coefcient for Tenure continues to be signicantly negative. The coefcient for Specialist is also negative, but marginally signicant using a one-tailed test (t-stat 1.4).21 In addition, the coefcient for the interaction term between Tenure and Specialist is signicantly positive, suggesting that the negative association between auditor tenure and discretionary accruals is weaker for client rms audited by industry specialists. 4.4. Low balling tests In order to evaluate the low balling explanation, we identify a sample of rms that are more likely to be associated with low balling. We limit our analyses to rms with auditor tenure of not more than 3 years in the period 20002004 for which audit fee data are publicly available. This results in a sample of 1087 rm-year observations. Of the 1087 observations, 178 report audit fees below one standard deviation from the predicted level, and they fall into the low balling sub-sample (LowBall 1). The rest of the observations (N 909) is considered non-low balling (LowBall 0). To provide some construct validity for the LowBall variable, we compare the mean audit fees for the low balling rms during the low balling period (i.e. rst 3 years of their engagement) with the later period, i.e. after 3 years of their engagement. If the LowBall variable correctly identies the rms that are associated with low balling, we expect their audit fees to be lower in the early years of audit engagement (low balling period) compared to later years (non-low balling
20 Tests based on full sample with an interaction variable may be less precise under certain circumstances when coefcients of control variables may differ between the two groups (e.g. Hardy, 1993). In order to overcome this weakness, it has been suggested that separate regression tests on the two groups be conducted, which will provide better results when the association between the X variable (auditor tenure) and Y variable (discretionary accruals measures) is hypothesized to be contingent on the moderator variable Z (auditor specialisation), which assumes two values (specialists or non-specialists) (e.g. Staw and Oldham, 1978; Wright et al., 1996, p. 452). Consequently our inferences are mainly drawn based on the sub-sample analyses. 21 As an additional test (untabulated), we remove all interaction terms (except for Tenure Specialist) and nd that the coefcient for Specialist becomes signicantly negative, consistent with prior studies (e.g. Balsam et al., 2003).

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Table 3 Association between ABSTDA, auditor tenure and auditor industry specialization: analyses using interaction terms. Dependent variable: ABSTDA Coeff. Intercept Tenure Specialist Tenure Specialist Age Size Size2 Size3 IndGrow Grow CFO Age Specialist Size Specialist Size2 Specialist Size3 Specialist IndGrow Specialist Grow Specialist CFO Specialist YearDum IndustryDum YearDum Specialist IndustryDum Specialist Pseudo-R2 N 1.371 0.382 1.699 0.241 0.142 0.726 0.064 0.001 0.047 0.006 4.597 0.215 0.240 0.019 0.000 0.470 0.001 0.454 Yes Yes Yes Yes 0.137 32,777 t-Stat 1.8 6.3 1.4 2.1 2.1 9.5 7.4 6.1 0.2 2.9 31.2 1.7 1.7 1.0 0.2 1.1 0.3 1.4 p-Value (0.07) (0.00) (0.17) (0.03) (0.03) (0.00) (0.00) (0.00) (0.83) (0.00) (0.00) (0.09) (0.08) (0.31) (0.87) (0.26) (0.77) (0.16)

Estimation is based on truncated regression approach. t-Values are reported in italics. p-Values (two-tailed) are reported in parentheses. Variable Denitions: ABSTDA absolute value of discretionary accruals scaled by average total assets (based on Ball and Shivakumar 2006); Tenure log of auditor tenure, measured as the number of consecutive years that the rm has retained the auditor; Age log of rm age, measured as the number of years that the rm appeared in Compustat since 1950; Size, Size2 & Size3 market value of equity (in 10 billions) to the power one, two and three; PN P IndGrow N i1 Salesi;t = i1 Salesi;t 1 by Fama and Frenchs (1997) 48 industry groups; Grow rm-specic sales growth, measured as Salest/Salest1; CFO rms cash ow from operations divided by average total assets; Specialist dummy variable, equals 1 for rms audited by auditor whose market shares is highest in terms of clients total asset for each industry group, 0 otherwise; YearDum dummies for scal years; IndustryDum dummies for Fama and Frenchs (1997) 48 industry groups.

period). We nd that the mean audit fees for the low ball period is 0.17% of total assets and that for the later period is 0.27%, and the difference is statistically signicant (t-stat 5.3).22 This result is consistent with the low balling phenomenon, which our LowBall variable is intended to capture. We rst compare absolute discretionary accruals between the rms that are likely to be associated with low balling and those that are not. The means of ABSTDA for low balling and non-low balling rms are 4.35% and 4.20%, respectively, and the difference is not statistically signicant (t-stat 0.85). The univariate test results thus suggest that our nding on the association between short tenure and earnings quality is not consistent with the low balling explanation. Next, we run a regression test on the reduced sample of 1087 observations with ABSTDA as the dependent variable and include the LowBall dummy variable as an independent variable (descriptive statistics of this smaller sample are reported in Panel A of Table 4). The results (Model 1) reported in Panel B of Table 4 show that the coefcient for LowBall is statistically insignicant, suggesting that there is no signicant association between ABSTDA and rms that are likely to be associated with low balling. We also include the LowBall dummy variable in the full sample with both short tenure and long tenure observations during the period 20002004 (N 13,062) in the model. Results for Model 2 show that the coefcient for Tenure is signicantly negative, as expected, while the LowBall coefcient continues to be insignicantly different from zero. In addition, we repeat our test in Table 2 using 20002004 data by including the LowBall variable as an additional control. Results in Panel C of Table 4 are qualitatively similar to that in Table 2, in that the negative association between Tenure and ABSTDA is stronger in the non-specialist group when compared to the specialist group. The coefcients for

22 We also compare audit fees of the non-low balling rms for the rst 3 years of their audit engagements with the later years of their audit engagements. The mean audit fee for the early years is 0.38% of total assets and that for the later period is 0.34%. The difference in mean audit fees is not statistically signicant (t-stat 1.4), suggesting that auditors of the non-low balling rms, unlike their low balling counterparts, do not charge signicantly lower audit fees in the early years of their audit engagements.

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Table 4 Tests for low balling. Panel A: Descriptive statistics of low balling samples Sample Variable ABSTDA Tenure (raw) Tenure (log) Age (raw) Age (log) Size Size2 Size3 IndGrow Grow CFO LowBall Short tenure (o4 years) sample, 20002004 (N 1087) Mean 4.57% 2.848 1.037 10.054 1.999 0.187 0.924 9.861 1.076 0.469 0.013 0.492 Median 3.10% 3.000 1.099 8.000 2.079 0.023 0.001 0.000 1.078 1.141 0.045 0.000 SD 4.637 0.359 0.146 9.220 0.767 0.943 11.092 150.981 0.138 12.389 0.220 0.500 Full sample, 20002004 (N 13,062) Mean 4.21% 9.709 2.042 14.148 2.405 0.257 1.615 28.893 1.075 0.873 0.005 0.056 Median 2.65% 8.000 2.079 1.000 2.398 0.024 0.001 0.000 1.076 1.060 0.060 0.000 SD 5.194 6.954 0.680 11.235 0.684 1.245 27.804 52.140 0.141 15.199 0.229 0.230

Panel B: Association between ABSTDA and low balling Dependent variable: ABSTDA Sample Model 1: Short tenure (o4 years) sample, 20002004 Coeff. Intercept Tenure LowBall Age Size Size2 Size3 IndGrow Grow CFO YearDum IndustryDum Pseudo R2 N 2.912 0.208 0.415 1.808 0.337 0.015 0.852 0.043 2.199 Yes Yes 0.106 1087 t-Stat 1.0 0.8 2.0 2.4 1.9 1.6 0.7 3.9 3.2 p-Value (0.32) (0.45) (0.05) (0.02) (0.06) (0.12) (0.48) (0.00) (0.00) Yes Yes 0.144 13,062

Model 2: Full sample, 20002004 Coeff. 2.458 0.260 0.254 0.170 0.541 0.041 0.001 0.150 0.003 5.633 t-Stat 3.2 2.9 1.3 1.9 5.4 3.7 2.8 0.4 1.2 26.9 p-Value (0.00) (0.00) (0.20) (0.06) (0.00) (0.00) (0.00) (0.66) (0.24) (0.00)

Panel C: Association between ABSTDA and auditor tenure, partitioned by auditor industry specialization (controlling for low balling) Dependent variable: ABSTDA Non-specialists Coeff. Intercept Tenure Lowball Age Size Size2 Size3 IndGrow Grow CFO YearDum IndustryDum Pseudo R2 N Diff in coeff. F-value p-Value 1.925 0.308 0.223 0.133 0.706 0.064 0.001 0.092 0.003 5.495 Yes Yes 0.139 9335 6.75 (0.00) t-Stat 1.8 2.7 0.9 1.2 4.8 3.8 3.2 0.2 0.8 22.3 p-Value (0.06) (0.01) (0.38) (0.24) (0.00) (0.00) (0.00) (0.84) (0.40) (0.00)

Specialists Coeff. 3.523 0.140 0.312 0.308 0.430 0.037 0.001 0.610 0.002 5.958 Yes Yes 0.162 3727 t-Stat 3.3 1.0 1.0 2.1 2.6 1.6 1.3 1.3 0.4 14.6 p-Value (0.00) (0.33) (0.31) (0.03) (0.01) (0.10) (0.21) (0.20) (0.67) (0.00)

Estimations are based on truncated regression approach. t-Values are reported in italics. p-Values (two-tailed) are reported in parentheses. The sample includes observations with audit fee data in the period 20002004. Variable Denitions: ABSTDA absolute value of discretionary accruals scaled by average total assets (based on Ball and Shivakumar, 2006); Tenure log of auditor tenure, measured as the number of consecutive years that the rm has retained the auditor; LowBall dummy variable, equals 1 for rms with auditor tenure below or equal to 3 years and the audit fee is below one standard deviation from the predicted audit fee (predicted using model discussed in Appendix A), 0 otherwise; Age log of rm age, measured as the number of years that the rm appeared in Compustat since 1950; Size, Size2 & P PN Size3 Market value of equity (in 10 billions) to the power one, two and three; IndGrow N i1 Salesi;t = i1 Salesi;t1 by Fama and Frenchs (1997) 48 industry groups; Grow rm-specic sales growth, measured as Salest/Salest1; CFO rms cash ow from operations divided by average total assets; Specialist dummy variable, equals 1 for rms audited by auditor whose market shares is highest in terms of clients total asset for each industry group, 0 otherwise; YearDum dummies for scal years; IndustryDum dummies for Fama and Frenchs (1997) 48 industry groups.

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LowBall are not statistically signicant in both sub-samples. The R2 of these regressions are similar to those reported in Table 2.23 The results in Table 4, which are also consistent with Coate and Loeb (1997) based on their two-period analytical model, indicate that low balling is not associated with lower audit quality. The low balling tests results, however, need to be viewed with caution for the following reasons. First, our conclusion is only valid to the extent that our LowBall variable correctly identies the rms that are associated with low balling. Classication of rms as low balling thus depends on correct estimation of the normal level of audit fees, which, in turn, depends on the extent to which the audit fee model is well-specied. Second, although we obtain similar results by using different cut-offs (e.g. the bottom quartile of negative abnormal fees, one standard deviation below the projected audit fees) for identication of low balling rms, the fact remains that we do not nd signicant results for the LowBall variable, which raises concerns with regard to the power of our tests. Lastly, even if the low balling explanation is not supported by our results, we cannot unambiguously exclude other possible alternative explanations for the short tenure/low earnings quality relationship using this test. 4.5. Additional analyses 4.5.1. Self-selection and endogeneity It is possible that discretionary accruals and auditor tenure are endogenously determined, i.e. rms with lower discretionary accruals may be motivated to retain auditors for a longer period or auditors are less likely to drop clients with lower discretionary accruals. To control for endogeneity, we employ a two-stage least-squares regression (2SLS) approach to obtain consistent and efcient estimators. In the rst stage, we obtain the predicted value of Tenure, which is then used in the second stage regression. Our Tenure prediction model is augmented from the auditor choice model used by Chaney et al. (2004). Specically, we estimate the following rst stage equation: Tenure a b1 Aturn b2 DA b3 Curr b4 Quick b5 ROA b6 ROA LOSS b7 Export b8 Litigation b9 Lag ABSTDA b10 Age b11 Size b12 Size2 b13 Size3 b14 IndGrow b15 Grow b16 CFO bj IndustryDum bk YearDum  (3) where Tenure is the log of auditor tenure, measured as the number of consecutive years that the rm has retained the auditor; Aturn is the asset turnover, measured as sales divided by total assets; DA is the debtasset ratio, measured as longterm debt divided by total assets; Curr the current ratio, measured as current assets divided by total assets; Quick is the quick ratio, measured as current assets minus inventory divided by current liabilities; ROA is the earnings before interest and taxes divided by total assets; Loss is the dummy variable, 1 if the rm incurred a loss in the previous year, 0 otherwise; Export is the foreign sales divided by total sales; Litigation is the dummy variable, 1 of the rm operates in a high-litigation industry, and 0 otherwise. High-litigation industries are industries with SIC codes of 28332836, 35703577, 36003674, 52005961 and 73707370 (Ashbaugh et al., 2003); Lag(ABSTDA) is the lag values of ABSTDA; Age is the log of rm age, measured as the number of years that the rm appeared in Compustat since 1950; Size, Size2 & Size3 are the market value of PN P equity (in 10 billions) to the power one, two and three; IndGrow is the N i1 Salesi;t = i1 Salesi;t 1 by Fama and Frenchs (1997) 48 industry groups; Grow is the rm-specic sales growth, measured as Salest/Salest1; and CFO is the rms cash ow from operations divided by average total assets. The model controls for rm size (Size, Size2 & Size3), rm complexity (Aturn, Curr, Quick, Export), and rm risk (DA, ROA, ROA LOSS), which are likely to be associated with auditor retention, as the incumbent auditor would have a better understanding of the clients business. Firm age (Age) is included because mature rms are more likely to retain an auditor that is likely to provide high audit quality. Direction of the Litigation variable a priori is not clear. It is possible that rms in more litigious industries are motivated to retain the incumbent auditors to provide more credibility to their reports. On the other hand, it is also possible that auditors may be motivated to drop the client rms from more litigious industries to reduce their litigation risk. Firms with higher earnings quality (Lag(ABSTDA)) are likely to retain the incumbent auditor to provide positive signals to the market on their earnings quality. The model also controls for industry and year xed effects. In addition, control variables in the second stage equation are also included, as suggested in Larcker and Rusticus (2008). The sample for this model drops to 26,756 observations because of additional data requirements. The results for the rst and second stage estimations are presented in Panel A of Table 5. The results for the rst stage estimation (Panel A) show that Tenure is positively associated with Size, Age, CFO, Cur and Quick,24 and negatively associated with Lag(ABSTDA). In addition, the results show that partial R2 is reasonably high and partial F is statistically signicant, suggesting that the model is unlikely to be subject to weak instrument problems (i.e. situations where the instrument and the regressor exhibit a small correlation) (see Larcker and Rusticus, 2008).
23 In a sensitivity test, we re-estimate Table 2 results after excluding observations with auditor tenure less than 4 years, since low balling affects auditors in their early years of audit engagement. As a result of excluding potential low balling rms, our sample drops to 27,804. The regression results (untabulated) are similar to the results contained in Table 2, suggesting that the positive association between discretionary accruals and relatively shorter tenure is weaker for auditor industry specialists. We obtained similar results when we exclude rms with auditor tenure less than 3 years. This is consistent with our earlier evidence of not nding a signicant association between low balling and discretionary accruals. 24 This is consistent with Chaney et al. (2004).

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The second stage results are consistent with our earlier ndings. Although the magnitude of the coefcients for predTenure are much smaller in the second stage results, the coefcient for predTenure is still signicantly negatively associated with ABSTDA for the non-specialists sub-sample. While the predTenure coefcient for the sub-sample of industry specialists is also statistically signicant, the magnitude of this coefcient is signicantly smaller (F-stat 23.46), consistent with our earlier evidence. Hiring of specialist auditors may also be endogenously determined,25 i.e. rms with high earnings quality hire audit specialists. We address this issue by conducting 2SLS tests with an interaction term. The predicted values for Specialist and Tenure are used in the second stage estimation to evaluate the joint effect of industry specialists and tenure on ABSTDA. The results are reported in Panel B of Table 5. The results for the Specialist model show that there is a signicantly positive association between industry specialists and Size, Litigation and DA, suggesting that larger rms, rms from more litigious industry groups, and rms with higher debt-to-assets ratios are likely to hire industry specialists. The coefcients for Aturn, Lag(ABSTDA) and Age are signicantly negative, suggesting that mature rms, rms with higher asset turnover and rms with higher levels of discretionary accruals are more likely to hire non-specialists. While the partial F (6.03) is still statistically signicant (suggesting that the predicted variable does not suffer from a weak instrument problem), the partial R2 is very low (0.025), implying that our model for specialists endogeneity is weak. In the second stage estimation, we include predTenure, predSpecialist and the interaction term between predTenure and predSpecialist in the model for the full sample, as in Table 3.26 The results for this second stage regression (Panel B) show that predTenure is negatively associated with discretionary accruals, and the coefcient is signicant. The coefcient for the interaction term between predTenure and predSpecialist is signicantly positive, suggesting that auditor industry specialization moderates the negative association between predTenure and ABSTDA. Consistent with our earlier results, the association between discretionary accruals and auditor tenure is signicantly weaker for rms audited by industry specialists. While 2SLS results are consistent with our main ndings, some cautions in their interpretation are warranted. Low R2 of the Specialist model suggests that validity of the instrument for Specialist may be questionable. Unfortunately, there is no complete structural model on the determinants of Specialist in the literature to provide us with guidance. In order to test endogeneity for both rst stage models, we perform the over-identifying restriction test (see Hausman, 1978; Godfrey and Hutton, 1994) and also the Hausman (1978) test. The results (untabulated) show that the Hausman (1978) test for endogeneity is signicant for both Tenure (t-stat 51.18, p-valueo0.01) and Specialist (t-stat 10.76, p-valueo0.01) models, rejecting the hypothesis of no endogeneity. The results of the over-identifying restriction test for both Tenure (tstat 15.22, p-valueo0.01) and Specialist (t-stat 10.59, p-valueo0.01) models are also signicant, which implies that the instruments constructed in this study are not totally exogenous and uncorrelated with the error term. However, following Larcker and Rusticus (2008) and Francis and Lennox (2008) we conduct tests to assess the extent of the endogeneity problem and sensitivity of our results to endogeneity. These additional tests are conducted by including different combinations of the explanatory variables in the rst stage models (exclude each of the explanatory variable from the models [one at a time] except for the obvious determinants, such as size). Intuition for these tests is that if the instruments are not valid, tests based on a different set of determinants might produce different estimates of the true coefcients. The results of these tests show that our main results are not sensitive to these alternative specications.

4.5.2. Signed discretionary accruals In our main analyses we use the absolute value of discretionary accruals as a measure of earnings quality, which captures the combined effect of income-increasing and income-decreasing earnings management decisions (Wareld et al., 1995; Myers et al., 2003). Some researchers (e.g. Ashbaugh et al., 2003), however, argue that earnings overstatements are more frequent and of greater concern to auditors, as they are likely to be associated with opportunistic earnings management. On the other hand, while the use of negative discretionary accruals (i.e. downward adjustment of reported earnings) could be opportunistic, it may also be considered as a form of conservative accounting (Ashbaugh et al., 2003). Thus, we conduct separate tests on observations with positive (income-increasing) and negative (income-decreasing) discretionary accruals. The results are reported in Table 6. The results for the sub-sample of positive discretionary accruals (POSTDA) are similar to the results for the full sample reported in Table 2 i.e. the Tenure coefcient is negative and signicant for the non-specialists sub-sample, and insignicant for the specialists sub-sample. The results for the sub-sample of negative discretionary accruals (NEGTDA*1), however, show that while shorter auditor tenure is associated with more negative discretionary accruals (in the All column), the positive association is stronger for the non-specialists sub-sample compared to the specialists sub-sample. If more negative
We thank the anonymous reviewer and the editor for drawing attention to the endogenous nature of hiring industry specialists. Discussions with some econometricians suggested that there should be no problem in using two predicted variables in the same second stage equation, even though the two variables are estimated utilizing identical variables. This might cause problems only when the coefcients of the two rst stage equations are the same, and therefore the two predicted variables are essentially the same variable. Panel B of Table 5 shows that the estimated results of the two equations are different, so are the R2 and F-values. In addition, we also nd that the correlation between the two predicted variables (PredTenure and PredSpecialist) is rather low (0.09).
26 25

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Table 5 Tests of endogeneity. Panel A: Partition analyses using two stage least squares Variable First-stage (Dep. Var. Tenure) Second-stage (Dep. Var. ABSTDA) Non-specialists Coeff. Intercept predTenure Aturn DA Curr Quick ROA ROA LOSS Export Litigation Lag (ABSTDA) Age Size Size2 Size3 IndGrow Grow CFO YearDum IndustryDum Adj. R2 (Partial R2) N F-stat (Partial F-stat) Diff in coeff. F-value p-Value 0.207 0.001 0.011 0.040 0.002 0.027 0.021 0.080 0.016 0.004 0.684 0.051 0.004 0.000 0.036 0.001 0.056 Yes Yes 0.461 (0.460) 26,756 305.82 (298.5) t-Stat 2.8 0.2 0.7 2.3 3.4 0.8 0.6 1.5 1.3 3.4 122.6 6.9 4.6 3.9 1.6 1.5 2.6 p-Value (0.01) (0.82) (0.51) (0.02) (0.00) (0.44) (0.54) (0.14) (0.20) (0.00) (0.00) (0.00) (0.00) (0.00) (0.12) (0.13) (0.01) Yes Yes 0.128 20,062 45.660 23.46 (0.00) Coeff. 2.796 0.065 t-Stat 2.980 6.320 p-Value (0.00) (0.00) Specialists Coeff. 2.814 0.031 t-Stat 2.740 2.080 p-Value (0.01) (0.04)

0.489 0.700 0.063 0.001 0.081 0.002 4.479

7.980 7.800 6.290 5.230 0.310 0.180 26.560

(0.00) (0.00) (0.00) (0.00) (0.76) (0.86) (0.00)

0.390 0.511 0.045 0.001 0.596 0.004 5.274 Yes Yes 0.143 6694 18.240

4.140 4.210 2.590 1.920 1.660 0.270 17.330

(0.00) (0.00) (0.01) (0.05) (0.10) (0.79) (0.00)

Panel B: Test of interaction term using two stage least squares Variable First-stage (Dep. Var. Tenure) Coeff. Intercept predTenure predSpecialist predTenure predSpecialist Aturn DA Curr Quick ROA ROA LOSS Export Litigation Lag(ABSTDA) Age Size Size2 Size3 IndGrow Grow CFO Age predSpecialist Size predSpecialist Size2 predSpecialist Size3 predSpecialist IndGrow predSpecialist Grow predSpecialist CFO predSpecialist YearDum 0.207 t-Stat 2.8 p-Value (0.01) First-stage (Dep. Var. Specialist) Coeff. 0.509 t-Stat 7.0 p-Value (0.00) Second-stage (Dep. Var. ABSTDA) Coeff. 2.796 0.065 0.018 0.033 t-Stat 3.1 6.5 0.0 1.7 p-Value (0.00) (0.00) (0.99) (0.08)

0.001 0.011 0.040 0.002 0.027 0.021 0.080 0.016 0.004 0.684 0.051 0.004 0.000 0.036 0.001 0.056

0.2 0.7 2.3 3.4 0.8 0.6 1.5 1.3 3.4 122.6 6.9 4.6 3.9 1.6 1.5 2.6

(0.82) (0.51) (0.02) (0.00) (0.44) (0.54) (0.14) (0.20) (0.00) (0.00) (0.00) (0.00) (0.00) (0.12) (0.13) (0.01)

0.022 0.046 0.004 0.000 0.039 0.022 0.033 0.020 0.004 0.016 0.066 0.005 0.000 0.010 0.001 0.024

5.3 2.7 0.3 0.7 1.2 0.7 0.6 1.7 3.8 3.0 9.2 6.3 4.8 0.4 1.2 1.2

(0.00) (0.01) (0.79) (0.50) (0.25) (0.51) (0.53) (0.09) (0.00) (0.00) (0.00) (0.00) (0.00) (0.67) (0.22) (0.25)

0.489 0.700 0.063 0.001 0.081 0.002 4.479 0.099 0.188 0.018 0.000 0.515 0.006 0.795 Yes

8.2 8.0 6.5 5.4 0.3 0.2 27.2 0.8 1.2 0.8 0.2 1.1 0.3 2.2

(0.00) (0.00) (0.00) (0.00) (0.75) (0.86) (0.00) (0.40) (0.23) (0.40) (0.86) (0.27) (0.76) (0.03)

Yes

Yes

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Table 5 (continued ) Panel B: Test of interaction term using two stage least squares Variable First-stage (Dep. Var. Tenure) Coeff. IndustryDum Adj. R (Partial R ) N F-stat (Partial F-stat)
2 2

First-stage (Dep. Var. Specialist) Coeff. Yes 0.026 (0.025) 26,756 10.420 (6.03) t-Stat p-Value

Second-stage (Dep. Var. ABSTDA) Coeff. Yes 0.133 26,756 31.980 t-Stat p-Value

t-Stat

p-Value

Yes 0.461 (0.460) 26,756 305.82 (298.5)

Estimation(s) of the rst-stage model is (second-stage models are) based on OLS approach (truncated regression approach). t-Values are reported in italics. p-Values (two-tailed) are reported in parentheses. Variable Denitions: ABSTDA absolute value of discretionary accruals scaled by average total assets (based on Ball and Shivakumar 2006); Tenure log of auditor tenure, measured as the number of consecutive years that the rm has retained the auditor; Specialist dummy variable, equals 1 for rms audited by auditor whose market shares is highest in terms of clients total asset for each industry group, 0 otherwise; Aturn asset turnover, measured as sales divided by total assets; DA debtasset ratio, measured as long-term debt divided by total assets; Curr current ratio, measured as current assets divided by total assets; Quick quick ratio, measured as current assets minus inventory divided by current liabilities; ROA earnings before interest and taxes divided by total assets; Loss dummy variable, 1 if the rm incurred a loss in the previous year, 0 otherwise; Export foreign sales divided by total sales; Age log of rm age, measured as the number of years that the rm appeared in Compustat since 1950; Litigation dummy variable, 1 of the rm operates in a high-litigation industry, and 0 otherwise. High-litigation industries are industries with SIC codes of 28332836, 35703577, 36003674, 52005961 and 73707370 (Ashbaugh et al., 2003); Lag(ABSTDA) lag values of ABSTDA; Age log of rm age, measured as the number of years that the rm appeared in Compustat since 1950; Size, Size2 & Size3 Market value of equity (in 10 billions) to the power one, two and PN P three; IndGrow N i1 Salesi;t = i1 Salesi;t 1 by Fama and Frenchs (1997) 48 industry groups; Grow rm-specic sales growth, measured as Salest/ Salest1; CFO rms cash ow from operations divided by average total assets; YearDum dummies for scal years; IndustryDum dummies for Fama and Frenchs (1997) 48 industry groups.

Table 6 Tests on signed measures of discretionary accruals. Panel A: POSTDA and NEGTDA Dependent variable: POSTDA All Intercept 2.462 2.9 (0.00) 0.338 4.8 (0.00) 0.201 2.5 (0.01) 0.513 6.2 (0.00) 0.044 4.8 (0.00) 0.001 3.8 (0.00) 0.057 0.2 (0.83) 0.011 4.8 (0.00) 4.808 27.0 (0.00) Yes Yes Non-specialists 2.195 2.1 (0.04) 0.451 5.2 (0.00) 0.103 1.1 (0.29) 0.635 6.0 (0.00) 0.058 4.9 (0.00) 0.001 4.2 (0.00) 0.055 0.2 (0.86) 0.015 5.6 (0.00) 4.609 22.4 (0.00) Yes Yes Specialists 2.983 2.2 (0.03) 0.094 0.8 (0.45) 0.456 3.3 (0.00) 0.297 1.9 (0.06) 0.026 1.1 (0.25) 0.001 0.8 (0.44) 0.031 0.1 (0.94) 0.001 0.1 (0.90) 5.287 14.7 (0.00) Yes Yes [NEGTDA*1] All 2.484 2.9 (0.00) 0.270 3.7 (0.00) 0.193 2.4 (0.02) 0.897 8.9 (0.00) 0.095 6.2 (0.00) 0.002 4.9 (0.00) 0.060 0.2 (0.83) 0.000 0.1 (0.92) 4.635 23.9 (0.00) Yes Yes Non-specialists 1.922 1.7 (0.09) 0.340 3.8 (0.00) 0.135 1.4 (0.17) 1.137 8.0 (0.00) 0.145 5.8 (0.00) 0.004 4.5 (0.00) 0.204 0.6 (0.54) 0.004 1.3 (0.19) 4.555 20.3 (0.00) Yes Yes Specialists 3.586 3.0 (0.00) 0.214 1.7 (0.09) 0.221 1.6 (0.12) 0.648 4.3 (0.00) 0.061 2.6 (0.01) 0.001 2.0 (0.05) 0.791 1.7 (0.09) 0.009 2.0 (0.04) 4.736 11.9 (0.00) Yes Yes

Tenure

Age

Size

Size2

Size3

IndGrow

Grow

CFO

YearDum IndustryDum

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Table 6 (continued ) Panel A: POSTDA and NEGTDA Dependent variable: POSTDA All Pseudo R2 N Diff in coeff. F-value p-Value 0.143 16,865 Non-specialists 0.144 12,495 14.4 (0.00) Specialists 0.154 4370 [NEGTDA*1] All 0.128 15,912 Non-specialists 0.123 11,938 9.1 (0.00) Specialists 0.152 3974

Panel B:NEGTDA: Extreme pre-managed earnings versus non-extreme pre-managed earnings Dependent variable: [NEGTDA*1] Sample Observations with extreme pre-managed earnings All Intercept 1.307 0.8 (0.45) 0.429 2.7 (0.01) 0.196 1.1 (0.26) 2.602 8.5 (0.00) 0.414 6.2 (0.00) 0.016 5.2 (0.00) 0.083 0.1 (0.90) 0.002 0.3 (0.74) 5.157 14.0 (0.00) Yes Yes 0.192 6364 Non-specialists 0.826 0.4 (0.70) 0.547 2.8 (0.01) 0.096 0.5 (0.65) 2.883 7.3 (0.00) 0.455 5.3 (0.00) 0.017 4.5 (0.00) 0.471 0.6 (0.54) 0.007 1.2 (0.21) 5.107 12.2 (0.00) Yes Yes 0.177 4837 5.35 (0.01) Specialists 2.444 0.8 (0.41) 0.487 1.7 (0.09) 0.185 0.6 (0.56) 2.823 4.7 (0.00) 0.581 3.4 (0.00) 0.032 2.8 (0.01) 1.342 1.1 (0.27) 0.016 1.8 (0.08) 5.097 6.4 (0.00) Yes Yes 0.249 1527

Observations with non-extreme pre-managed earnings All 2.451 9.6 (0.00) 0.019 0.9 (0.39) 0.072 2.8 (0.00) 0.074 2.4 (0.01) 0.009 2.1 (0.03) 0.000 2.0 (0.05) 0.037 0.4 (0.67) 0.001 1.9 (0.06) 1.207 16.8 (0.00) Yes Yes 0.082 9548 Non-specialists 2.595 8.0 (0.00) 0.031 1.1 (0.25) 0.047 1.5 (0.12) 0.130 2.6 (0.01) 0.022 1.8 (0.08) 0.001 1.4 (0.17) 0.063 0.6 (0.53) 0.002 1.9 (0.05) 1.206 14.9 (0.00) Yes Yes 0.082 7101 0.65 (0.52) Specialists 2.490 5.8 (0.00) 0.001 0.0 (0.99) 0.147 2.9 (0.00) 0.023 0.5 (0.64) 0.004 0.7 (0.51) 0.000 0.8 (0.41) 0.141 0.8 (0.44) 0.000 0.1 (0.90) 1.205 7.5 (0.00) Yes Yes 0.093 2447

Tenure

Age

Size

Size2

Size3

IndGrow

Grow

CFO

YearDum IndustryDum Pseudo R2 N Diff in coeff. F-value p-Value

Estimations are based on truncated regression approach. t-Values are reported in italics. p-Values (two-tailed) are reported in parentheses. Pre-managed earnings is computed as the difference between earnings and NEDGTDA. It is considered extreme when pre-managed earnings is either in the top or bottom quintiles. Variable Denitions: POSTDA positive value of discretionary accruals scaled by average total assets (based on Ball and Shivakumar, 2006); NEGTDA negative value of discretionary accruals scaled by average total assets (based on Ball and Shivakumar, 2006); Tenure log of auditor tenure, measured as the number of consecutive years that the rm has retained the auditor; Age log of rm age, measured as the number of years that the rm appeared in Compustat since 1950; Size, Size2 & Size3 market value of equity (in 10 billions) to the power one, two and three; PN P IndGrow N i1 Salesi;t = i1 Salesi;t 1 by Fama and Frenchs (1997) 48 industry groups; Grow rm-specic sales growth, measured as Salest/Salest1; CFO rms cash ow from operations divided by average total assets; Specialist dummy variable, equals 1 for rms audited by auditor whose market shares is highest in terms of clients total asset for each industry group, 0 otherwise; YearDum dummies for scal years; IndustryDum dummies for Fama and Frenchs (1997) 48 industry groups.

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discretionary accruals are interpreted as a more conservative application of GAAP, this result by itself is not supportive of our expectation. In the current development of the literature, it is not clear ex-ante whether NEGTDA should be interpreted as downward earnings management or conservative reporting. To further investigate this issue, we identify a smaller sample in which managers have a stronger incentive to opportunistically manage earnings using NEGTDA. For example, prior studies (e.g. Healy, 1985; Gaver et al., 1995; Holthausen et al., 1995) suggest that managers have an incentive to smooth earnings or manage income downwards when it far exceeds certain thresholds. In the other extreme, managers will have an incentive to take a big bath when income is very low, so that they can report larger earnings in the following years (Healy, 1985; Walsh et al., 1991). We divide the NEGTDA sample into two groups based on the managerial incentives to opportunistically manage earnings downwards, using the magnitude and sign of the pre-managed earnings (incomeNEGTDA). In particular, we argue that when the pre-managed earnings are either very high or very low, managers will have greater incentives to smooth income or take a big bath using NEGTDA. Thus, rms with very high or very low pre-managed earnings are more likely to be the rms that opportunistically manage earnings using NEGTDA. When pre-managed earnings are not extreme, managerial incentives to manage earnings downward will be lower, and the NEGTDA in these rms is less likely to be opportunistic earnings management that lowers the quality of earnings.27 To operationalize this test, we select the top and bottom 20% of pre-managed earnings to represent extreme earnings; the rest of the observations in the NEGTDA sample are considered less extreme earnings.28 Regression results for each group are reported in Panel B of Table 6. The coefcient for Tenure in the extreme pre-managed earnings group is signicantly negative, consistent with the results for the total negative discretionary accruals group contained in Panel A, whereas it is insignicant for the group of non-extreme pre-managed earnings. These results thus suggest that managers of the extreme pre-managed earnings group have a stronger incentive to manage earnings downward using NEGTDA. To the extent that extreme earnings is an appropriate measure of the stronger managerial incentive to use NEGTDA opportunistically, our ndings for NEGTDA provide evidence consistent with our expectations and earlier results for POSTDA and ABSTDA.

4.5.3. Alternative specications of auditor tenure As an additional test, we differentiate between medium and long audit tenure following the procedure used by Johnson et al. (2002). Instead of a continuous variable, we use two indicator variables for medium length of the auditorclient relationship (MEDIUM equals one when the length of the auditorclient relationship is four to 8 years, and zero otherwise) and long tenure (LONG equals one when the length of the auditorclient relationship is 9 years or longer, and zero otherwise), with short tenure (3 years or below) as the default group.29 In addition, we also adopt a more restrictive denition of longer auditor tenure (TenDum), as suggested in Carcello and Nagy (2004). Auditor tenure is considered long (TenDum 1) when an auditor is on the job for 9 years or longer, and considered short (TenDum 0) when the auditor is on the job for 3 years or less. The observations with auditor tenure between 4 and 8 years are dropped from the analyses, reducing the sample size to 13,723. The results are reported in Table 7. The results of these tests are similar to our earlier ndings. Specically, we nd that auditors with both medium tenure (MEDIUM 1) and long tenure (LONG 1) are associated with lower ABSTDA if the rms are audited by industry nonspecialists, but not when rms are audited by an industry specialists. Although the coefcient for LONG is also marginally signicant for the specialist group using a one-tailed test (t-stat 1.5), we nd that the magnitude of the coefcients for both MEDIUM and LONG are signicantly larger for the non-specialist sub-sample than that for the specialist sub-sample. In addition, we nd that the magnitude of the coefcients for LONG is also signicantly larger than that for MEDIUM for both the specialists (F-stat 4.6) and the non-specialists (F-stat 10.3) samples, suggesting that the level of ABSTDA is further lower when auditor tenure is 9 years or more. The results on TenDum are also qualitatively similar to our main results.30 In theory, non-specialists are expected to be able to accumulate sufcient client-specic knowledge at some point of time to ensure high-quality earnings, assuming that the operations as well as the business environment of the client remain constant over time. Our results, however, suggest that 48 years may not be a sufcient time for non-specialist auditors to acquire enough client-specic knowledge. This is not surprising given the dynamic nature of business operations and the changing business environments. It is possible that auditors benet from the accumulation of new client-specic knowledge as time goes. As such, it may be difcult to predict at what point the auditor learning is sufcient. We leave this issue for future research.
27 The NEGTDA in this group might reect conservative application of GAAP, and might also reect other motives for downward earnings management. As a result, we do not have an expectation for this group of rms in terms of their association between earnings quality, auditor tenure, and industry specialization. 28 As sensitivity analyses we use other cut-offs such as top and bottom quartiles, 33% and one standard deviation, and results (untabulated) are qualitatively similar. 29 Johnson et al. (2002) use the medium length of auditorclient relationship as the default group. However, since our focus is on the short tenure/ lower earnings quality relationship, we use auditor tenure fewer than 4 years as the default group. 30 Interaction analyses are again sensitive to alternative specications due to possible multicollinearity problems. For example, our results (untabulated) show that the interaction term between MEDIUM (LONG) and Specialist is signicantly negative (positive), which is consistent with our main ndings, while the interaction term between TenDum and Specialist is statistically insignicant.

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Table 7 Alternative denitions for auditor tenure. Dependent variable: ABSTDA Tenure variable MEDIUM and LONG All Intercept 2.534 4.1 (0.00) 0.306 2.7 (0.01) 0.530 4.5 (0.00) Non-specialists 2.241 2.8 (0.00) 0.459 3.3 (0.00) 0.688 4.7 (0.00) Specialists 3.208 3.5 (0.00) 0.073 0.4 (0.70) 0.309 1.5 (0.12) 0.451 3.7 (0.00) 0.304 5.7 (0.00) 0.616 10.3 (0.00) 0.051 7.5 (0.00) 0.001 5.8 (0.00) 0.100 0.5 (0.60) 0.005 3.2 (0.00) 4.726 36.0 (0.00) Yes Yes 0.135 32,777 MEDIUM LONG 0.289 4.5 (0.00) 0.735 9.4 (0.00) 0.065 7.3 (0.00) 0.001 6.0 (0.00) 0.044 0.2 (0.85) 0.005 2.8 (0.01) 4.596 30.3 (0.00) Yes Yes 0.131 24,433 5.97 (0.00) 12.84 (0.00) 0.348 3.7 (0.00) 0.481 4.6 (0.00) 0.044 2.9 (0.00) 0.001 2.2 (0.03) 0.435 1.4 (0.17) 0.004 1.4 (0.16) 5.037 19.0 (0.00) Yes Yes 0.151 8344 TenDum 0.437 4.5 (0.00) 0.532 7.9 (0.00) 0.041 5.7 (0.00) 0.001 4.3 (0.00) 0.103 0.4 (0.72) 0.010 3.6 (0.00) 4.970 21.2 (0.00) Yes Yes 0.126 13,723 10.1 (0.00) 0.621 4.1 (0.00) 0.409 3.3 (0.00) 0.660 7.4 (0.00) 0.055 5.7 (0.00) 0.001 4.6 (0.00) 0.011 0.0 (0.97) 0.011 3.1 (0.00) 4.720 17.4 (0.00) Yes Yes 0.127 10,229 0.351 1.7 (0.10) 0.523 3.3 (0.00) 0.395 3.3 (0.00) 0.036 2.2 (0.03) 0.001 1.7 (0.09) 0.478 0.9 (0.38) 0.009 1.9 (0.06) 5.672 12.2 (0.00) Yes Yes 0.135 3494 TenDum (below 4 vs. above 9 years) All 3.787 4.1 (0.00) Non-specialists 3.663 3.1 (0.00) Specialists 4.456 3.1 (0.00)

MEDIUM

LONG

TenDum

Age

Size

Size2

Size3

IndGrow

Grow

CFO

YearDum IndustryDum Pseudo R2 N Diff in coeff. F-value p-Value F-value p-Value

Estimations are based on truncated regression approach. t-Values are reported in italics. p-Values (two-tailed) are reported in parentheses. Variable denitions: ABSTDA absolute value of discretionary accruals scaled by average total assets (based on Ball and Shivakumar, 2006); MEDIUM dummy variable, equals 1 when the length of the auditorclient relationship is medium (48 years); zero otherwise; LONG dummy variable, equals 1 when the length of the auditorclient relationship is long (9 years or longer); zero otherwise; TenDum dummy variable, equals 1 for auditorclient relationship is 9 years or longer, 0 for auditorclient relationship is 3 years or below; Age log of rm age, measured as the number of years that the rm appeared in Compustat since 1950; Size, Size2 & Size3 market value of equity (in 10 billions) to the power one, two and three; PN P IndGrow N i1 Salesi;t = i1 Salesi;t 1 by Fama and Frenchs (1997) 48 industry groups; Grow rm-specic sales growth, measured as Salest/Salest1; CFO rms cash ow from operations divided by average total assets; Specialist dummy variable, equals 1 for rms audited by auditor whose market shares is highest in terms of clients total asset for each industry group, 0 otherwise; YearDum dummies for scal years; IndustryDum dummies for Fama and Frenchs (1997) 48 industry groups.

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4.5.4. Pre- and post-SOX periods Since our sample covers the periods before and after the Sarbanes-Oxley (SOX) Act of 2002, we repeat our analyses separately for each period. We include in this analysis only rms that exist in both the pre-SOX (19932001) and post-SOX (20022004) periods to partially control for the difference in the two samples caused by the change in sample composition. Based on this smaller sample, we investigate if the changes in the regulatory environment and auditing profession after the passage of SOX have any effect on the relationship between auditor tenure, auditors industry specialization and earnings quality. The results (untabulated) show that the magnitudes of coefcients for Tenure are negative and signicant for both periods but much smaller for the post-SOX period (coeff 0.261, t-stat 2.19) compared to the pre-SOX period (coeff 0.606, t-stat 6.05). These results thus indicate a comparatively weaker association in the post-SOX period.31 In addition, consistent with our main ndings, the test results (untabulated) for the low balling group show that the association between LowBall and ABSTDA is statistically insignicant for both pre-SOX (t-stat 0.49) and post-SOX (t-stat 0.65) periods. 4.6. Other earnings quality proxies 4.6.1. Alternative specications of discretionary accruals Robustness tests are also conducted using other measures of discretionary accruals. We re-estimate discretionary accruals using the modied Jones (1991) model (ABSJONES), as well as discretionary accruals based on the performanceadjusted modied Jones model (Ashbaugh et al., 2003; Kothari et al., 2005), which controls for the mechanical relation between current periods discretionary accrual estimate and rm performance. Additionally, we conduct tests using the accruals quality measure (AQ) developed in Dechow and Dichev (2002) and Francis et al. (2005b). In addition, following Francis et al. (2005b), we decompose AQ into innate and discretionary parts of AQ, and replace AQ with discretionary AQ (DISCAQ) since it is the discretionary component that is more likely to be associated with opportunistic earnings management behaviour. These results (untabulated) using all these alternative estimations are similar to those reported in Table 2, suggesting that our main results are not sensitive to different ways of estimating discretionary accruals.32 Recent research suggests that discretionary accruals estimated cross-sectionally can be noisy and bias the resulting tests if the rms in the industry are not homogeneous (Dopuch et al., 2005). As a robustness check, we repeat our tests based on discretionary accruals estimated for each rm using the time-series model. The regression results (untabulated) based on these discretionary accruals are qualitatively similar to our main ndings, suggesting that the measurement errors associated with industry heterogeneity is not likely to affect our conclusions. We conduct pairwise correlation tests on ABSTDA with discretionary accruals based on other models, and nd that the absolute discretionary accruals based on all models are signicant (po0.001) and highly correlated with each other (the correlation between ABSTDA and all the other ve models ranged from 0.33 [ABSTDA and ABSJONES] to 0.78 [ABSTDA and ABSTIME]). High correlations could indicate that the use of all discretionary models suffers from some specication problems, as has pointed out in the literature (e.g. Dopuch et al., 2005; Ball and Shivakumar, 2008). The extent and the type of the problems are, however, likely to be different for each measure, especially in cases when their correlations are relatively low. To the extent that each measure reects some different facet of the truly discretionary component, the consistent results we obtained based on different models show that our ndings are not sensitive to these alternative measures and the use of these measures does not work against our conclusions. 4.6.2. Tests based on absolute value of non-discretionary accruals (ABSNDA) In order to evaluate the behaviour of non-discretionary accruals, we conduct tests with absolute value of these accruals (ABSNDA) as the dependent variable. The results (untabulated) show that, consistent with our main ndings contained in Table 2, Tenure is negatively associated with ABSNDA (coeff 0.02, t-stat 2.52). In addition, the coefcient for Tenure is still signicantly negative for the non-specialist group (coeff 0.03, t-stat 2.84), whereas it is insignicant for the specialist group (coeff 0.00, t-stat 0.29). It should, however, be noted that the magnitude of the Tenure coefcients in this test are much lower than for discretionary accruals reported in Table 2, which may suggest that auditors are less concerned about non-discretionary accruals. We also conduct a test on ABSNDA with an interaction term between Tenure and Specialist (similar to Table 3), and the results (untabulated) show that the interaction term is insignicant (t-stat 0.11). Similar to the results contained in Table 4, the results of a test on the low balling group show that the association between LowBall and ABSNDA continues to be statistically insignicant (t-stat 0.30). 4.6.3. Meeting or beating earnings benchmarks In view of the concerns expressed in the literature with regard to the problems associated with the specication of discretionary accruals models (e.g. Dopuch et al., 2005; Ball and Shivakumar, 2008), we use the meeting or beating
31 A possible reason for weaker results in the post-SOX period is that the more stringent nancial reporting and auditing requirements mandated by SOX forced all auditors to offer higher quality services irrespective of the length of tenure and/or industry specialization (Ettredge et al., 2007). 32 We nd that the results (untabulated) of a regression test with an interaction between Tenure and Specialist are similar to those reported in Table 3 for all models except for discretionary accruals estimated using the modied Jones model (1991).

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earnings benchmarks as alternative measures of earnings quality. A stream of research (e.g. Burgstahler and Dichev, 1997; Ashbaugh et al., 2003) argues that rms with small increase in earnings or rms with earnings just meeting or beating analyst earnings forecasts are more likely to engage in earnings management. Therefore, we use the likelihood of rms reporting small earnings increases (INCREASE) and the likelihood of rms meeting or beating analyst earnings forecasts (SURPRISE) as additional earnings quality proxies. We expect that rms with longer tenured auditors are less likely to be associated with INCREASE or SURPRISE, and this association is expected to be signicantly weaker for rms audited by industry specialists. We conduct our tests based on the following logit model (see also Ashbaugh et al., 2003 who use a similar model):
INCREASE=SURPRISE a b1 Tenure b2 Litigation b3 MB b4 LnMVE b5 IH b6 LOSS b7 TDA bj IndustryDum bk YearDum 

(4) where INCREASE is the dummy variable, 1 when the increase in net income, scaled by average total assets, falls in the interval [0.00, 0.02], and 0 otherwise; SURPRISE is the dummy variable, 1 when a rm meets or beats by 1 cent the mean consensus analysts forecast as reported in IBES database, and 0 otherwise; Tenure is the log of auditor tenure, measured as the number of consecutive years that the rm has retained the auditor; Litigation is the dummy variable, 1 if the rm
Table 8 Earnings benchmark tests. Dependent variable INCREASE All Intercept 2.231 1023.0 (0.00) 0.056 4.4 (0.04) 0.172 23.6 (0.00) 0.012 40.6 (0.00) 0.219 588.0 (0.00) 0.215 10.2 (0.00) 1.538 1012.5 (0.00) 0.012 11.0 (0.00) Yes Yes 0.177 25,868 Yes Yes 0.179 19,196 3.66 (0.03) Non-specialists 2.354 800.0 (0.00) 0.057 3.1 (0.08) 0.169 16.7 (0.00) 0.012 31.5 (0.00) 0.244 498.6 (0.00) 0.174 4.8 (0.03) 1.481 708.7 (0.00) 0.010 6.3 (0.01) Specialists 1.924 219.9 (0.00) 0.055 1.3 (0.25) 0.173 6.2 (0.01) 0.010 8.3 (0.00) 0.165 99.8 (0.00) 0.279 4.9 (0.03) 1.709 302.1 (0.00) 0.017 5.2 (0.02) Yes Yes 0.175 6672 Yes Yes 0.060 19,493 12.3 (0.02) SURPRISE All 1.820 541.5 (0.00) 0.059 4.1 (0.04) 0.251 47.8 (0.00) 0.003 2.4 (0.13) 0.116 126.5 (0.00) 0.529 52.8 (0.00) 0.639 219.4 (0.00) 0.014 14.9 (0.00) Yes Yes 0.060 14,205 Non-specialists 1.830 384.2 (0.00) 0.068 3.6 (0.06) 0.256 36.4 (0.00) 0.004 2.2 (0.14) 0.122 94.6 (0.00) 0.510 34.6 (0.00) 0.628 153.9 (0.00) 0.015 13.0 (0.00) Specialists 1.793 153.3 (0.00) 0.045 0.7 (0.39) 0.233 11.0 (0.00) 0.002 0.3 (0.61) 0.105 32.2 (0.00) 0.566 17.8 (0.00) 0.668 65.2 (0.00) 0.011 2.2 (0.14) Yes Yes 0.060 5288

Tenure

Litigation

MB

LnMVE

IH

Loss

TDA

YearDum IndustryDum Pseudo R2 N Diff in coeff. F-value p-Value

Logistic estimations are conducted. Chi-squares are reported in italics. p-Values are reported in parentheses. Variable Denitions: INCREASE dummy variable, 1 when the increase in net income, scaled by average total assets, falls in the interval [0.00, 0.02], and 0 otherwise; SURPRISE dummy variable, 1 when a rm meets or beats by 1 cent the mean consensus analysts forecast as reported in IBES database, and 0 otherwise; Tenure log of auditor tenure, measured as the number of consecutive years that the rm has retained the auditor; Litigation dummy variable, 1 if the rm operates in a high-litigation industry (industries with SIC codes of 28332836, 35703577, 36003674, 52005961 and 73707370), and 0 otherwise; MB market to book ratio, dened as market value of equity divided by stockholders equity of common shareholders; LnMVE log of market value of equity; IH percentage of shares held by institutional owners; Loss dummy variable, 1 if the rm incurred a loss in the previous year, 0 otherwise; TDA discretionary accruals scaled by average total assets; Specialist dummy variable, equals 1 for rms audited by auditor whose market shares is highest in terms of clients total asset for each industry group, 0 otherwise; YearDum dummies for scal years; IndustryDum dummies for Fama and Frenchs (1997) 48 industry groups.

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operates in a high-litigation industry (industries with SIC codes of 28332836, 35703577, 36003674, 52005961 and 73707370), and 0 otherwise; MB is the market to book ratio, dened as market value of equity divided by stockholders equity of common shareholders; LnMVE is the log of market value of equity; Loss is the dummy variable, 1 if the rm incurred a loss in the previous year, 0 otherwise; IH is the percentage of shares held by institutional owners; and TDA is the discretionary accruals scaled by average total assets. Additional data required for these tests reduce the sample size to 25,868 (19,493) observations for the INCREASE (SURPRISE) regression. The results are reported in Table 8. After controlling for other factors, Tenure is negatively associated with both INCREASE and SURPRISE in the total sample, suggesting that rms with longer tenured auditors are less likely to meet or beat earnings benchmarks. We then split the sample into the specialists and non-specialists groups. As shown in Table 8, the negative association between tenure and both INCREASE and SURPRISE is signicantly stronger in the non-specialists sub-sample than in the specialists sub-sample. We also estimate regression on the full sample with interaction terms (similar to Table 3), and nd insignicant results (untabulated) for the interaction terms. However, the variance ination factors (VIFs) for regressions with the interaction terms are very high, indicating signicant multicollinearity. To the extent that meeting or beating earnings benchmarks is an appropriate alternative measure for earnings quality in the audit quality context, the results of these tests are consistent with our main ndings and provide additional support for our expectation that auditors industry specialization moderates the association between auditor tenure and earnings quality.

5. Conclusion This paper provides evidence that auditors industry specialization affects the relationship between auditor tenure and earnings quality, as documented in prior studies (e.g. Myers et al., 2003; Johnson et al., 2002). Our main results show that the association between shorter auditor tenure and lower quality of reported earnings is weaker for rms audited by industry specialists. One possible explanation of these results might be that auditors with industry expertise in the clients business are more likely to detect irregularities and misrepresentations and provide higher quality audits, even if auditors lack client-specic knowledge as a result of short auditorclient relationships. Our results do not provide support for the low balling explanation for the short tenure/low-quality earnings relationship. While our study is subject to the usual limitations of empirical studies of this type, some important caveats are worth emphasizing. First, validity of our results depends on the appropriateness of the proxies for earnings quality. There is no consensus on the superiority or higher reliability of any particular model for estimating discretionary accruals (Bartov et al., 2000; Dechow et al., 1995; Nichols, 2000). Some recent studies argue that discretionary accrual models are mis-specied and suffer from errors-in-variables problems (e.g. Dopuch et al., 2005; Ball and Shivakumar, 2008). In order to address these concerns, we use earnings benchmark tests as alternative proxies for earnings quality. Second, our results for the low balling tests may be inuenced by the lack of power of our tests. Third, it is also possible that there may be alternative explanations for the association between shorter auditor tenure and earnings quality, which have not been explored or tested in this paper. For example, the lower quality earnings for rms audited by short-tenured non-specialists may be due to high-quality auditors dropping risky clients (especially those with high discretionary accruals) in the rst few years of audit engagements. We believe that this is not a signicant concern in the results documented in this study, since our tests are based on a sample that include only rms audited by Big N auditors, and exclude non-Big N auditors where dropped (riskier) clients are likely to go. Lastly, in view of the difculties in specifying correct models for determining the choice of Tenure and Specialist, our results using 2SLS procedures have not fully overcome the underlying endogeneity problem. We leave these and other issues for future research.

Appendix A. Estimation of expected audit fees Following prior studies (e.g. Gul and Tsui, 1998; Francis et al., 2005a), we estimate the following regression model to obtain the predicted audit fees for the period 20002004, where audit fee data is available: LAF b0 b1 LTA b2 LSEG b3 CATA b4 QUICK b5 DE b6 ROI b7 FOREIGN b8 OPINION b9 YE b10 LOSS fixedeffects  where LAF is the log of audit fees (in thousands of dollars); LTA is the log of total assets (in millions of dollars); LSEG is the log of the number of unique business segments; CATA is the ratio of current assets to total assets; QUICK is the ratio of current assets (excluding inventories) to current liabilities; DE is the ratio of long-term debt to total assets; ROI is the ratio of earnings before interest and tax to total assets; FOREIGN is the proportion of total sales from foreign operations; OPINION is the dummy variable coded 1 for modied audit report, and 0 otherwise; YE is the dummy variable coded 1 for non-Dec. 31 year end, and 0 otherwise; LOSS is the dummy variable coded 1 if loss in current scal year, and 0 otherwise; xedeffects are the year and industry dummy variables and e is the random-error term with the usual normality properties.

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Control variables represent rm complexity, audit risk, rm size (LTA), the audit opinion (OPINION) and a December scal year end (YE). The rm complexity variables are LSEG and FOREIGN. The audit risk variables include CATA, DE, LOSS, QUICK and ROI. Audit fee data is extracted from Audit Analytics. Firms with auditor tenure below 4 years are excluded from the estimation. The summary statistics of the estimation sample as well as the estimation result are reported below in Tables A1 and A2, respectively. Our results are consistent with the results reported in the prior studies (Francis et al., 2005a).

Table A1 Descriptive statistics of the audit fee estimation sample (N 6739). Variable Audit fees (in millions) LAF Total assets (in millions) LTA No. of Segments LSEG CATA QUICK DE ROI FOREIGN OPINION YE LOSS Mean 0.866 1.070 2092.380 5.538 2.010 0.471 0.538 3.010 0.159 0.050 0.125 0.039 0.282 0.450 Median 0.285 1.256 214.030 5.366 1.000 0.000 0.548 1.602 0.079 0.045 0.000 0.000 0.000 0.000 Std Dev 2.256 1.196 8564.180 1.987 1.545 0.634 0.255 5.010 0.200 0.324 0.231 0.194 0.450 0.498

Table A2 Regression estimation of expected audit fees. Dependent variable: LAF Intercept LTA LSEG CATA QUICK DE ROI FOREIGN OPINION YE LOSS Fixedeffects Adj. R2 N Variables are as previously dened. Coefcient 4.055 0.514 0.192 0.454 0.028 0.164 0.310 0.223 0.297 0.214 0.115 Included 0.764 6739 t-Stat 31.8 106.0 15.0 10.2 17.1 3.9 10.8 6.8 7.5 12.4 6.6 p-Value (0.00) (0.00) (0.00) (0.00) (0.00) (0.00) (0.00) (0.00) (0.00) (0.00) (0.00)

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