Erasmus school of Economics
Master thesis for the master Accounting, Auditing & Control
Mandatory auditor
rotation and
conservatism in
financial reporting
The change of dynamics in the auditor-client relationship.
Geert Venderink(318721)
2/19/2014
Coach: Dr. Sc. Ind. A. H. Van der Boom
Co-reader: E.A. De Knecht RA
Foreword
This thesis was written from March 2013 till March 2014 under supervision of university lecturer
A.H. (Ton) Van der Boom (coach) and university lecturer E.A.(Evert) De Knecht (co-reader) on
the Erasmus University Rotterdam, faculty Erasmus School of Economics.
The intent of this thesis is to investigate whether there is a higher level of accounting
conservatism in the last year of the auditor client relation compared to years prior and after that
rotation.
I would thank my supervisor for the lecturers in the Master curriculum that attracts my attention
to conservatism in financial reporting. In addition in the writing and research process he provides
me with great input to direct me to a performable research and structured thesis.
During the absence of my supervisor, mister De Knecht took charge of the supervision and
provides me with great input to finalize my thesis. I would like to thank for this great effort and
time.
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Table of content
1. Introduction ............................................................................................................................... 5
1.1 Motivation ........................................................................................................................................... 6
1.2 Research Question .............................................................................................................................. 8
1.3 Sample................................................................................................................................................. 9
1.4 Relevance .......................................................................................................................................... 10
1.5 Limitations ........................................................................................................................................ 11
1.6 Structure of the thesis........................................................................................................................ 12
2 Background .............................................................................................................................. 13
2.1 Mandatory auditor rotation: history and arguments .......................................................................... 13
2.2 Mandatory auditor rotation: current comments................................................................................. 15
2.3 Background literature........................................................................................................................ 16
2.4 Conservatism..................................................................................................................................... 17
2.5 Agency theory ................................................................................................................................... 21
2.6 Positive accounting theory ................................................................................................................ 22
2.7 Market Based Accounting Research ................................................................................................. 23
2.8 Summary ........................................................................................................................................... 23
3. Models to measure the use of conservatism .......................................................................... 25
3.1 Basu (1997) ....................................................................................................................................... 25
3.2 Givoly and Hayn (2000) ................................................................................................................... 26
3.3 Summary ........................................................................................................................................... 29
4. Empirical findings in literature ............................................................................................. 30
4.1 Balance sheet conservatism in experimental setting, Wang & Tuttle (2009) ................................... 30
4.2 The influence of the audit tenure on the audit quality, Johnson et al. (2002) and Myers et al. (2003)
................................................................................................................................................................ 32
4.3 Balance sheet conservatism in Europe, Joos & Lang (1994) ............................................................ 33
4.4 Difference in timeliness of bad news and good news in Earnings: Earnings conservatism, Basu
(1997) ...................................................................................................................................................... 34
4.5 Development of earnings and balance sheet conservatism in the US, Givoly & Hayn (2000)......... 35
4.6 Empirical findings of Conservatism in Europe, Garcia Lara & Mora (2004)................................... 40
4.7 Earnings conservatism with different auditor tenures, Kramer et al. (2011) .................................... 42
4.8 Summary ........................................................................................................................................... 42
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5. Hypothesis................................................................................................................................ 45
5.1 Hypothesis development ................................................................................................................... 45
5.2 Summary ........................................................................................................................................... 48
6. Research design ....................................................................................................................... 49
6.1 Research method, model proxies and statistical analysis.................................................................. 49
6.2 Additional quality tests ..................................................................................................................... 53
6.3 Sample selection ............................................................................................................................... 54
6.4 Collect data ....................................................................................................................................... 57
6.5 Attainability ...................................................................................................................................... 58
6.6 Summary ........................................................................................................................................... 58
7. Outcomes ................................................................................................................................. 60
7.1 Accumulation of operating accruals ................................................................................................. 60
7.2 Differential timeliness in recognizing bad and good news in earnings............................................. 63
7.3 Market to book ratio.......................................................................................................................... 66
7.4 Summary and general remarks about the tests .................................................................................. 69
8. Analysis and conclusion .......................................................................................................... 70
8.1 Findings............................................................................................................................................. 70
8.2 Comparison with prior research ........................................................................................................ 71
8.3 Conclusions ....................................................................................................................................... 73
8.4 Limitations ........................................................................................................................................ 74
8.5 Recommendations for further research ............................................................................................. 75
Bibliography ................................................................................................................................ 76
Appendices ................................................................................................................................... 80
Appendix 1 Literature review ................................................................................................................. 80
Appendix 2 (additional statistical outcomes) .......................................................................................... 84
2.1 SPSS outcomes Accumulation of operating Accruals ...................................................................... 84
2.2 SPSS outcomes Asymmetry in recognizing good and bad news in earnings ................................... 86
2.3 SPSS outcomes Asymmetry in recognizing good and bad news in earnings ................................... 88
2.4 SPSS outcomes Asymmetry in recognizing good and bad news in earnings ................................... 90
2.5 SPSS outcomes Market to book ratio test ......................................................................................... 91
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1. Introduction
Purpose of this thesis is to explain the influence of the mandatory audit firm rotation on the level
of the use of conservatism in financial reporting, especially focused on the last year of the
relation. Due to the fraud scandals and the financial crisis, mandatory audit firm rotation is
currently a hot topic in the political spectrum and the audit environment. In the European Union
the Euro Commissioner Michel Barnier presented a proposal to create a law which makes this
rotation mandatory every six years (accountancynieuws, 2012). In the Netherlands the
implementation of mandatory rotation is already going on. The scandals and the crisis caused a
call for higher audit quality. A benefit the legislators hope for is, due to the mandatory rotation of
the audit firm, that the auditor independence will increase (Commission, 2004). The auditor
independence implies that the auditor is independent of his client. Because dependency can
influence the critical attitude of the auditor to his job negatively and consequently harm the audit
quality no financial or familiar relation between the auditor and the client is allowed, except for
the audit contract. By the Dutch parliament two amendments are approved related to the
mandatory audit firm rotation. These amendments create the rotation of the auditor compulsory
for public-interest entities after eight years. This law is effective from January 2016 with
counting the eight years term in retrospective (Staten-Generaal, 2012).
In this thesis the relation between the mandatory auditor rotation and the use of conservatism
will be investigated. The content of the term conservatism in financial reporting implies that
losses are taken promptly when indications exist for losses and that positive results are
recognized gradually when enough certainty exists that the benefits are realized by the company
(Watts, 1993). A more in depth explanation of the term conservatism will be provided later in
this chapter. For the theoretical explanation of conservatism and the methods in which way to
determine this, with a data study, is provided in chapter two.
The drivers for this thesis are the current discussion about the upcoming mandatory auditor
rotation and its possible consequences for the use of conservatism in the annual financial
reporting. In this chapter, a short introduction will presented to the topic of the mandatory
auditor rotation. In addition in this chapter the use of conservatism will be explained. After these
two theoretical concepts the research question of this thesis will be presented.
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1.1 Motivation
The legislators expect a higher degree of independence of the auditor when the relation between
the client and the auditor is maximized for a predefined number of years. Due to this increase in
independence as signaled earlier, indirectly the legislators expect a higher degree of the audit
quality. The purpose of this thesis is not to determine what the influence is on the audit quality,
but on the use of conservatism in the annual financial reporting, with a special attention for the
last year of the relation with the auditor. The use of conservatism is not a synonym of the term
audit quality, but conservatism could influence the information usefulness in the annual financial
statements. In case of the use of accounting conservatism, a difference exists between the fair
value and the reported value (book value) of an asset. This is qualified as balance sheet
conservatism. In addition earnings conservatism is the understatement of earnings in the
financial statements. This distinction will be explained further in paragraph 2.4. In prior studies,
mainly performed in the US, a change in the behavior of the auditor is found. When different
audit tenures were compared, this change in behavior caused a different degree of the audit
quality. This change in behavior will be further commented in chapter three, but no thorough
research is performed on its relation with the use of conservatism, if there is any. The motivation
for this thesis is to fill this gap in the existing research.
Relevant aspects of audit profession
Several aspects of the audit profession and in which way audit firms are structured are relevant
concerning the expectations of the use conservatism in case of the mandatory auditor rotation.
Characteristics of the audit profession exist that could imply the use of more conservatism
characteristics and that imply less use of conservatism. This tension caused by the mutual
characteristics is the reason to perform this research.
Rotation of audit firms creates a new dynamic in the profession. The year after the rotation the
audit files and the financial report will be critically analyzed by a new auditor. In case of a
disputed asset value, the rotated auditor has to explain the approved presented values and the
approved assertions to the new auditor. This will influence his attitude towards the audit job in
the last year related to the acceptance of the certain valuations of assets. This changing attitude in
the last year will cause the use of more conservatism.
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Another factor causing the use of more conservatism in the last year is the wish of the auditor to
diminish his litigation risk. Litigation risk for the auditor is lower when more conservative
reporting is used (Wang & Tuttle, 2009). Because the litigation risk is higher in case of an
overstatement than in case of an understatement, litigation by shareholders or other stakeholders,
who rely on the reported figures, encourages the use of conservatism in financial accounting
(Watts, 1993). When reporting is more conservative losses are taken when there are just
indications for losses and positive results are only reported when enough certainty exists that the
benefits by the company are realized (Watts, 1993). Because a smaller chance of overstatement
exists, when conservatism in financial accounting is used, shareholders are less able to litigate
the company or the auditor based on an overstatement of earnings or balance values. Because the
audit relation with the client will end anyway, the auditor does not have to be afraid for a harmed
audit relation when he accepts only more conservative balance values. Because the audit firm
wants to maintain his position at the client company in the form of advisory tasks, on the
contrary, the auditor cannot act too conservative. A non-cooperative attitude will harm a positive
relationship; consequently the use of conservatism is bounded to a certain degree.
An increase in competition in the audit market is presented as a positive aspect of the mandatory
rotation. When he displays a certain attitude towards his client, the auditor has to be aware of the
reputational aspects. Because this will harm his reputation in the market place, an auditor is not
able to display a very conservative attitude towards the management assertions.
In addition the auditor was auditing the client for more than only the last year of the relationship.
Approvals about the valuation of balance items in the balance sheet in prior years cannot be
recovered in the last year of the auditor-client relation. The auditor is bound by his decisions
related to the financial statements he formulated in these prior years.
All these aspects indicate a tension, expecting both a higher and a lower degree of the use of
conservatism in the financial statements in the last year of the audit-client relation. These
conflicting expectations creates that performing this research is attractive.
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1.2 Research Question
Concerning this thesis the next research question is formulated:
Does a higher degree of accounting conservatism exist in the last year before rotating the
auditor, in relation to prior years?
To create a clear structure in this thesis the next sub-questions are formulated, parallel to the
chapter structure:
Sub-question 1
What are the definition and the background of the mandatory auditor rotation and accounting
conservatism (in the regulation and in comments)?
Sub-question 2
In prior research which models are used to measure the use of conservatism?
Sub-question 3
What are the results of prior research on conservatism and in which way does this research
contribute to answer the research question?
Sub-question 4
Which hypothesis is formulated based on the research question and prior literature to answer
the research question?
Sub-question 5
Which research design will be used to test the formulated hypotheses and to answer the research
question?
Sub-question 6
What are statistical results of the empirical research?
Sub-question 7
Which conclusions are derived from the analysis of the statistical results and the comparison
with results of prior research?
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To answer the research question an archival study will be performed, in which data is analyzed
of firms that switched their auditor and the years prior and after that switch. Because the use of
conservatism is related to the topic of the information usefulness, this is a market-based
accounting research. Information usefulness research is an example of market-based accounting
research, the relation between the accounting numbers and stock prices is the object of this
thesis. Because no neutrality exists in determining the firm’s value, this affects the ability for the
investors to determine the fundamental value of the firm, consequently the use of conservatism
affects the value relevance of the published accounting numbers.
1.3 Sample
In this study the influence of the mandatory audit rotation on the use of conservatism will be
investigated. Mandatory audit firm rotation only exists in a few countries and it is hard to obtain
the data where this rotation is mandatory. In addition, the standards differ too much in these
countries to derive conclusions relevant for the western markets(for example Taiwan and South
Korea).
To perform a research on the topic of rotation of the auditor the data of three European countries
are used, namely The Netherlands, Belgium and Germany. In none of these countries auditor
rotation was mandatory (in the Netherlands it is mandatory from 2016), what creates a limitation
on drawing conclusion related to the consequences of the mandatory auditor rotation. These
countries are chosen, because they have cultural similarities and they have a comparable law and
litigation system (Garcia Lara, 2004). Besides that, the three countries together resulted in a large
enough sample to perform statistical tests. In 2005 these three countries implemented the
International Financial Reporting Standards (IFRS). Due to this uniformity in these used
reporting standards the comparability between the selected countries is improved. Before the
implementation of IFRS some major differences in the reporting standards exists. For example,
the German standards for financial reporting were to a great extent based on tax regulation
because tax laws are primarily based on historical costs that implies more conservative reporting.
This conservatism is confirmed in the study by Garcia, Lara & Mora (2004). In their sample
based on eight European countries, they found the most extreme use of balance sheet
conservatism in Germany, but the other code law countries in this study (The Netherlands,
Belgium and France) were not significantly different. To determine the influence of the
mandatory auditor rotation on the use of conservatism it is wise to control for the implementation
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of IFRS and the differences between countries. In the study of Garcia Lara & Mora (2004) the
Netherlands, Germany and France were quite comparable in their use of conservatism, due to the
corresponding political, cultural and regulatory environment in the countries.
In the sample countries no law is implemented which enforces the mandatory rotation of the
audit firm; consequently the research is bounded by a limitation. The limitation is that the auditor
does not know years in advance that he is rotated in a predetermined year. In this study is tried to
mitigate this limitation by imposing requirements on the sample, namely the size of the firm and
whether the selected company is stock exchange quoted. In a setting with mandatory rotation the
auditor knows, before he audits the last year, that the relation will end after that year. In case of a
voluntary rotation the auditor is aware of this as well when he audits large stock exchange quoted
firms. In case of a voluntary rotation at a large firm the auditor already knows before the start of
the final audit, that the relation will last no longer than that year (Gray & Manson, 2008),
because a tender procedure introduces contracting of the new auditor. In the last decennia the
tender procedure is becoming more important in the continental European countries (Gray &
Manson, 2008). This tendering focuses more and more on the fee of the audit. Quality and
performed work is of secondary importance, so disputes about the values are not the main reason
for quitting the relationship with the auditor. Because auditors' awareness of rotating is
necessary, otherwise the observed use of conservatism is based on coincidence, the use of the
tender procedures creates that the data of the voluntarily rotating firms are relevant for the
proposed research. The sample requirement is the size of the firm, based on revenues and on the
balance value and whether it is stock exchange quoted or not.
1.4 Relevance
In the prior paragraph the topic of the mandatory rotation is presented and an introduction is
provided on the topic of the use of conservatism.
This thesis wants to provide input to the discussion about the mandatory audit rotation from a
different perpective. This thesis does not focus on the audit quality itself but on the use of
conservatism. Since IFRS is adopted in 2005 and the focus is more on fair value instead of the
use of conservative reporting, the use of conservatism is no longer the equivalent or a pure
indicator of the audit quality. Before IFRS most European countries used the national General
Accepted Accounting Principles (GAAP) with a conservative basis (Bertoni & Derosa, 2005).
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The Financial Accounting Standards Board (FASB), the financial reporting standard setter in the
United Sates, in addition supports and requires a more neutral way of reporting in the financial
statements as well (Whittington, 2008). With the extensive project to integrate the frameworks of
FASB and of the IASB, in their conceptual framework fair value is adopted, to create a higher
degree of neutrality in the external financial reporting (Bertoni & Derosa, 2005). Before
implementation of IFRS, when the financial reports were more conservative, better compliance
with the standards was met, implying a higher quality. Nowadays fair value is the base of the
new standards; consequently the use of more conservatism does not imply better compliance
with the standards any longer. But a change in the degree of the use of conservatism has
implications for users of the annual financial statements, which they should take into
consideration when analyzing the annual financial reports. Caused by the created differences
between book values and economic values, when conservatism is used, investigating this topic is
still relevant.
1.5 Limitations
When audit firm rotation is mandatory, the auditor knows before performing the audit that he
will be rotated after that year. When rotation is voluntary this rotation could be communicated
with the auditor after the audit and the use of conservatism imposed by the auditor could be
based on coincidence. To create a sample in which this knowledge of rotation is to a large extent
present before starting the audit; large stock exchanges quoted companies are selected. The
rotation of the auditor at this kind of firms is introduced on average with a tender procedure. This
is a formal procedure which often takes months before the new auditor is selected. With this
procedure the current auditor is aware before doing the final audit that it will be his last year of
the engagement. If the use of conservatism is observed this can possibly be ascribed to this
knowledge of rotation and not to coincidence. Due to the reason that rotation is not yet
mandatory, deriving conclusions need to be performed with great caution.
Another limitation is that the way of performing the research is a database research. In the
databases used no reason is stated, why the firm under study rotates the audit firm. This could be
caused by a dispute or financial distress of the firm. These reasons could all have a consequence
for the reported figures by the audit client. To mitigate continuity issues of the firms, when the
company is not present in the whole time-frame the firm years will excluded from the tests. Due
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to this measure the internal validity of the research is improved. Maybe, still correlated omitted
variables exist that in the models are not implemented as a control variable.
In addition the countries used in this thesis are not identical or highly comparable with other
countries in the western world. Country specific characteristics, like litigation and culture, limit
the possibility of the generalization of the findings.
1.6 Structure of the thesis
The remainder of this thesis is structured as follows. Chapter two presents the answer on the first
sub-question and consequently contains the comments about the background of the mandatory
audit rotation and the explanation of the use of accounting conservatism. The third chapter
provides the answer on the second sub-question and consequently, to measure the use of
accounting conservatism, presents models used in prior literature. The fourth chapter, in
conformity with the third sub-question, presents the empirical findings of the use of accounting
conservatism and in which way these studies contribute to answer the research question. The
fifth chapter, based on the research question and on the prior literature, contains the formulated
hypotheses. In addition the fourth sub-question will be answered. To answer the fifth subquestion, the sixth chapter presents the research design to test the formulated hypotheses. To
provide an answer on the sixth sub-question, the results of the research will be presented in
chapter 7. In chapter 8, the results of the empirical research will be analyzed and conclusions will
be derived. Based on that sub-question 7 will be answered.
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2 Background
In this chapter the answer is provided to the next sub-question: What are the definition and the
background of the mandatory auditor rotation accounting conservatism (in the regulation and in
comments)?
The evolution of regulation and the comments about mandatory audit rotation is presented.
Attention in this chapter is focused on the United States, on Europe and on The Netherlands.
Because in the US the discussion about mandatory auditor rotation started after the major fraud
scandals and the empirical research is further developed these three regions are chosen. The
Netherlands, because recently a law is implemented which forces stock exchange quoted firms to
rotate the audit firms every eight years and the European Union because it can implement laws
which are mandatory for many European countries and because they are implementing
mandatory rotation laws already. In addition, this chapter is used to explain the concept of the
use of conservatism. Which kinds of conservatism are known and which ones are subject of
research in this thesis.
This thesis is based on broader theories, the agency theory and the positive accounting theory.
These theories are the basis for the formulation of the hypothesis in chapter 5 and should be
taken into consideration while reading this thesis. That is why concerning the background of the
thesis these theories in this chapter in paragraph 2.5 and 2.6 are presented.
2.1 Mandatory auditor rotation: history and arguments
After the fraud scandals in the United States at the start of this century (Enron and Worldcom),
the role of the auditor was criticized and reevaluated. As a response to these scandals the
Sarbanes-Oxley Act (SOX) in 2002 in the United States was implemented. Extensive discussion
has been performed about both, the independence of the auditor and the methods to restore this
independence. To assure this independence, mandatory rotation was one of the commented
topics, to create a professional distance between the auditor and the audited client. Should this be
part of SOX as well or are less severe measures able to guarantee the independence of the
auditor? In section 207, SOX requires that the Government Accountability Office (GAO)
performs a study on the potential impact of the mandatory auditor rotation for public held
companies (Raiborn, Schorg, & Massoud, 2006). The results of this study were known in
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November 2003. With SOX this mandatory rotation was not implemented, a less radical measure
was implemented, namely audit partner rotation.
Arguments of mandatory rotation proponents and opponents
As signaled, in the period prior to the implementation of SOX, mandatory auditor rotation was
widely discussed. Arguments of proponents and opponents of this mandatory rotation are
summarized in the article by Raiborn, Schorg & Massoud (2006) who created an overview of all
arguments of the opposing parties. Their article is written with the American audit market in
mind, but the arguments are applicable to the European market as well. Proponents argue that a
longer tenure of the auditor on the audit of that specific client creates an unwilling familiarity.
The auditor becomes too familiar with the client and shall accept certain values of balance items
he would not accept when this relation was less familiar. Second, the public perception about the
independence is better when the audit rotation is mandatory. Third, the auditor is able to display
a more critical attitude towards the assertions of the client and experience no force to follow the
client blindly, because the pay-off of a good relationship is lower, due to the fact that the relation
has a maximum duration which is embedded in the law. Fourth, mandatory auditor rotation
would increase the competition of the auditors that cause a decrease in the audit fees. The fifth
argument proponents communicate, is that a rotation on a regular basis causes a fresh vision by
the new auditor. And last because the successor auditor shall review his work and shall disclose
the predecessors’ errors, the current auditor shall perform a better audit.
In addition, some argue that the costs of audit failures are larger than the costs of the mandatory
rotation of the auditor (Healy, 2004).
Arguments of opponents were provided as well in the article by Raiborn, Schorg & Massoud
(2006). The major argument of opponents, formulated by the authors, is that the quality of the
audit will be reduced when the rotation is mandatory. The auditor lacks knowledge of the client.
This point is supported by other authors as well (Arrunda & Paz-Ares, 1997). To become
familiar with the client the auditor has to invest much time to get aware of the practices in the
firm. It is empirically evidenced that the auditor needs two to three years to get familiar with the
practices, information systems and the nuances of the large clients (Raiborn, Schorg, &
Massoud, 2006). Because the auditor is not aware of all business and audit risks at the clients’
side, this time needed for learning about the client is associated with a greater risk of audit
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failure. Proponents argue that the audit market is more competitive, but opponents are afraid that
audit firms assign clients to the firms and divide the market, consequently the competition in the
market will be reduced. Because only four firms exist that are able to audit large companies
(KPMG, PwC, EY and Deloitte) this division of the market is possible in the audit market.
Another argument signaled by the authors is the decrease in specialization and the investment in
industry specific knowledge by audit firms, because too specific knowledge cannot be used at the
clients audit for the coming decennia, because the duration of the relation is limited. This
argument in addition is supported in the GAO study (2003). Based on the before signaled
arguments and the results of a survey under CEOs of the largest stock exchange quoted
companies in the United States the GOA decided not to implement the mandatory auditor
rotation and first observe the effects of the recently implemented SOX (Raiborn, Schorg, &
Massoud, 2006).
2.2 Mandatory auditor rotation: current comments
As a response to the financial crisis the discussion about the implementation of the mandatory
rotation of auditors started again. The Public Company Accounting Oversight Board (PCAOB)
has initiated the debate about this topic. In a concept release, which was issued on the 16th of
August 2011, the PCAOB communicated ways to improve the auditors’ independence, his
objectivity and an attitude of professional skepticism (PCAOB, 2011). This release can be
qualified as a reevaluation of the GAO study of 2003, when the PCAOB decided to wait with the
drastical measure to implement the mandatory auditor rotation, to determine what the
consequences of SOX were.
Proponents of the mandatory auditor rotation argue that it will enhance the auditors’ objectivity
and his independence. Because of the loss of cumulative knowledge of a client and they argue
that the benefits are questionable, opponents point out that the costs are very high (Tysiac, 2012).
In the European Union currently, a growing attention exists for the mandatory rotation of the
audit firms as well. On the 13th of October 2010 the Euro commissioner Michel Barnier (Internal
market) proposed to rotate the auditor of an organization every six years (Commission, 2011).
The European commission issued a green paper which is comparable with the concept release of
the PCAOB (Commission, 2011). They propose the mandatory auditor rotation to guarantee the
independence of the external auditor. This independence is one of the principals of the audit
15
profession that is a fundamental value of an independent audit report for the users of the annual
financial statements (Commission, 2011). Without any empirical support these legislators
assume that with imposing the mandatory auditor rotation the quality of the audit increases.
Because the implementation of these laws is in most countries in the European Union a new
phenomenon, not much research is performed concerning this topic. Mandatory auditor rotation
is a drastic way to enforce the market participants to act in a social responsible way (auditors to
be more independent), but not all the consequences of the mandatory auditor rotation are
positive. Findings of prior empirical research are unambiguous.
The debate about the mandatory auditor rotation in the Netherlands is further developed. Two
amendments are adopted on the 11th of December 2012, both with the aim to create a higher
degree of the independence of the auditor (NBA, 2012). One amendment is about the segregation
between the audit tasks and the advisory tasks and the other amendment is about the mandatory
rotation of the external auditor. Public interest entities (Organisaties van openbaar belang) are
forced to rotate their auditor every eight years, with a cool off period of four years (StatenGeneraal, 2012). This rotation starts at 2016, with counting the eight years term in retrospective.
2.3 Background literature
Due to the fact that not enough western countries exist with mandatory auditor rotation in place
(only Italy), in the empirical literature mandatory auditor rotation is not extensively investigated.
Performed research is mostly related to the auditor tenure and the audit quality (Myers, Myers, &
Omer, 2003) (DeFond & Subramanyam, 1998) (Johnson, Khurana, & Reynolds, 2002).
Measures used in these studies are partly relevant for this thesis, but the use of conservatism is
something different than the audit quality and the implications of the voluntary auditor rotation
are slightly different than the mandatory auditor rotation. Existing background literature, relevant
for this study, is presented in this paragraph.
Auditor tenure
Proponents of the mandatory audit firm rotation would argue that due to longer auditor tenure the
independence of the auditor will decrease what will consequently decrease the audit quality.
These long tenures will end when the mandatory rotation of the auditor is implemented. One of
the studies that investigated the relation between the auditor tenure and the audit quality is
16
performed by Myers, Myers and Omer (2003). To perform their analysis they use a sample of US
firms. The method used to determine the audit quality in their study is measuring the extreme
management reporting decisions. These extreme management reporting decisions are measured
with the extent of the accruals used by the management to increase the current period reported
earnings (Myers, Myers, & Omer, 2003). Accruals are used to identify these extreme reporting
decisions. Two accrual measures are used, discretionary and total accruals. A low level of
accruals implies that the audit quality is high (Myers, Myers, & Omer, 2003). First, by the
authors a univariate regression was performed, determining the relation between the auditor
tenure and the accruals. Afterwards, the authors performed a multivariate regression with control
variables for firm age and firm size. A comparable research is performed by Johnson, Khurana
and Reynolds (2002). The authors used the distinction between three tenures, a short tenure of 23 years, an average tenure of 4 till 8 years and longer tenures. Their predictions are that the
quality of the annual financial report is highest in an average tenure. Unexpected accruals are
their proxy for the financial reporting quality. The results and the conclusions of both studies will
be presented in chapter 4.
2.4 Conservatism
This paragraph is about the use of conservatism in general. What is the content of the term
conservatism in this thesis? What are the causes of the use of conservatism? And what is
published about it by other authors? Answering these questions is relevant for the research
approach in this thesis.
Conservatism is the differential verifiability of profit versus losses (Basu, 1997). In financial
reporting this implies that bad news is faster incorporated in the annual financial statements than
good news; what is qualified as the differential timeliness of the earnings (Basu, 1997). The
definition of Basu (1997) captures prior definitions formulated by other authors on the topic of
the use conservatism and is specifically relevant for this thesis. He elaborates on his definition
and creates special emphasis on the role of the auditor to assess the determined value of the
assets in the annual financial statements performed by the management: The auditors’ tendency
to require a higher degree of verification to recognize good news as gains, than to recognize bad
news as losses (Basu, 1997). This definition is related to the use of earnings conservatism. The
17
distinction between the use of earnings conservatism and the balance sheet conservatism in this
chapter will be presented as well.
Concerning the tendency to be conservative, various reasons exist. In the descriptive study by
Watts (2003) four explanations of the use of accounting conservatism are provided:
1. Contracting
Watts argues that contracting is one of the main explanations for the use of conservatism.
Conservatism in accounting is able to reduce the opportunistic behavior of the firm’s
management, which is a significant risk for the principals of the firm. Problems
associated with opportunistic behavior by the firm’s management are primarily due to the
asymmetric information, the asymmetric payoffs, limited horizons and limited liability.
The moral hazard problem can be constrained by using conservative accounting.
2. Shareholder litigation
Litigation in addition produces asymmetric payoffs in that overstating the firm’s net
assets is more likely to generate litigation costs for the firm than understating net assets.
By understating net assets the use of conservatism reduces the firm’s expected litigation
costs.
3. Taxation
Taxation and reporting are linked. To require a lower level of verifiability for losses than
for profits firms can diminish the present value of the future taxations and consequently
increase the present value of the firm.
4. Regulation
Comparable to the asymmetry in the litigation costs for the management, in the
regulator’s costs for standard setters’ asymmetry exists. Standard setters and regulators
are likely to face more criticism if firms overstate the net assets than if they understate the
net assets. In this way, the use of conservatism in accounting reduces the political costs
imposed on the standard-setters and the regulators.
Earnings and balance sheet conservatism
Till now the reasons of the use of conservatism have been presented, but the elaboration in the
reported figures can have different forms. In the literature two types of conservatism are
distinguished: the balance sheet conservatism and the earnings conservatism (Garcia Lara, 2004).
18
Balance sheet conservatism could be explained as a persistent understatement of the asset values
and could be measured by the market-to-book ratio (Feltham & Olshon, 1995). This implies
when the balance value are conservatively stated this ratio has a value higher than 1. Because an
overvaluation or an undervaluation in the stock market could influence the market to book ratio
as well, this implies an efficient market. Because the values of assets (and book equity) are
understated relative to the economic values, balance sheet conservatism reduces the user
relevance of the balance sheet in an inefficient market.
Like commented before, earnings conservatism is defined as more timely recognition of bad
news than the recognition of good news (Basu, 1997). The use of earnings conservatism distorts
the income measurement process by deferring the recognition of increases in economic values
until the realization occurs, while encouraging accelerated recognition of losses in anticipation of
future adverse events.
Conditional and unconditional conservatism
In addition distinction exists between unconditional and conditional conservatism. Beaver &
Ryan (2005) describe the distinction as follows: Unconditional conservatism is news
independent (ex ante conservatism); implying that aspects of the accounting process determined
at the inception of assets and liabilities yield expected unrecorded goodwill (Beaver & Ryan,
2005). Examples are valuing assets for their historical costs while they have a positive net
present value, or accelerated depreciation faster than its economic lifespan.
Conditional conservatism is news dependent conservatism (ex post conservatism), implying that
assets are written-off under sufficiently adverse circumstances, but not corrected upwards under
favorable circumstances. Adjustments in book value are only made when certain conditions are
met (Beaver & Ryan, 2005). Examples are lower cost or market value for inventory or
impairment tests for goodwill.
In their paper, Beaver and Ryan (2005) stated that while the two types of conservatism have the
same purpose, minimizing firms' litigation, tax or regulatory costs, the two have different
implications and interact with each other. When unconditional conservatism is used in valuing
the assets, no goodwill is present in the value of the assets to write-off. This relation is tested by
Givoly and Hayn (2004). They found empirical evidence that higher unconditional conservatism,
measured with the market-to-book value, causes a smaller use of conditional conservatism,
19
measured with the asymmetry of good news and bad news in the earnings. This study of Givoly
and Hayn (2004) will extensively explain in chapters 3 and 4.
Earnings and balance sheet conservatism and conditional and unconditional conservatism can
occur in different combinations. For readers convenience the combinations are presented in a
scheme. Some combinations are presented in more columns.
Conservatism
Conditional
Unconditional
Balance sheet
-
Impairment of assets in
-
Accelerated depreciation
case of unfavorable
-
Non recognition of
-
circumstances
internally produced
Low cost or market value
intangible assets
for valuation of assets
-
Using lifo valuation for
inventory (instead of fifo)
when prices increase
Earnings
-
Bad news earlier than
-
good news
Fair value accounting
through equity
-
Accelerated depreciation
-
Using lifo valuation for
inventory (instead of fifo)
when prices increase
(Source: Boom, T. van der, Seminar Financial Accounting Research, January 2013, Erasmus University Rotterdam)
Authors on the topic of the use of conservatism only measure one or a few of the before
presented forms of the use of conservatism. To the before presented distinction will be referred
in later chapters. In chapter three the used types of conservatism in the measures of prior
researches will be presented and in chapter five and in chapter six the types of conservatism
investigated in this thesis will be determined. In chapter six the choice for certain types of
conservatism is supported.
Litigation risk and Conservatism
Kramer, Georgakopoulos, Sotiropoulos and Vasileiou (2011) used the use of conservatism as a
proxy of the earnings quality and compare this proxy in different audit tenures and at firms
20
rotating their auditor. Authors' expectation is that a higher degree of the use of conservatism
exists in the first year after the rotation. In addition, they expect that shorter tenures have a
higher degree in the use of conservatism than medium or long tenures. To determine the level of
the conservatism use in the published earnings the model of Basu (1997) is used. This model will
be explained in chapter 3. The findings of this study are presented in chapter 4.
2.5 Agency theory
A theory relevant for the predictions of the audit managers' behaviour related to the mandatory
auditor rotation is the Agency theory. This theory is introduced by Jensen & Meckling (1976).
The principal hires an agent to act on his behalf. In addition, the theory assumes that both actors
act primarily to satisfy their self-interest, but the agent has more information than the principal.
This information asymmetry causes that the principal cannot ensure that the agent operates in
principal's best interest (Jensen & Meckling, 1976). The costs of having an agent operating on
the principals' behalf are qualified as the agency costs. These are costs inherent with having an
agent (for example the costs when the agent uses principals’ resources for own purposes) and the
costs of the principal to align the interest of the agent with the interest of the principal (for
example an incentive scheme).
In an auditor-client relation, the client (a company) hires an auditor to perform the audit job. The
auditor is the agent and the client the principal. The principal wants to motivate the agent to
operate in the best interest of the principal, but due to the information asymmetry and the
possibility for the agent to operate in his own interest he can deviate from optimal behaviour
(Stiglitz, 1987). Because he had the ability to hire a different auditor the next year the client has
some leverage in negotiations about the approval of values of the balance items (Wang & Tuttle,
2009). Compared to the last year the auditor shall follow the assertions of management to a
greater extent in the early years of an auditor-client relation. The present value of the future audit
fees shall no longer outweigh the litigation risk in these last years (Wang & Tuttle, 2009). Every
year when the discounted value of the future audit fees diminishes, it lowers the incentives of the
audit firm to keep the client satisfied.
In addition, the responsible audit manager of the audit team is an agent of his audit firm at large.
The company goals of generating as much profit as possible on a company scale do not align
with the individual incentive schemes of the audit managers. The audit firm wants to establish a
client relation with the audit client after the mandatory audit firm rotation (Comunale & Sexton,
21
2005). This is a separate sub-unit in the audit firm responsible for the own revenues. Incentive
schemes need to be created to ensure that the audit managers will not harm the relation with the
client that could create that selling advisory tasks for the advisory sub-unit is impossible. Argued
based on an agency theory perspective, mandatory auditor rotation will cause more conservatism
in the last year before the rotation, due to both the before signalled reasons.
2.6 Positive accounting theory
Compared to prior years, this thesis expects other behavior of auditors in the last year of the
relation. Consequently, the Positive accounting theory (PAT) is relevant. This theory in 1978 is
introduced 1978 by Watts and Zimmerman (Watts & Zimmerman, 1978). The Agency Theory
signaled in paragraph 2.5 is an underlying idea of the PAT. Watts & Zimmerman (1978)
formulated based on empirical study and on prior literature, like the study of Jensen & Meckling
(1976), factors that describe, explain, and predict accounting choices of the management. The
factors signaled by Watts and Zimmerman (1978) are taxes, regulation, management
compensation plans, bookkeeping costs and political costs. These factors are just examples of
issues that could influence the accounting choices of the management. Later authors added more
factors, for example smoothing of earnings, meeting of earnings benchmarks (Graham, Harvey,
& Rajgopal, 2005). Based on a PAT perspective, a higher level in the use of conservatism in the
last year of the auditor-client relation in a situation with the mandatory audit firm rotation could
be predicted.
Audit firms operate every audit with an audit team. These teams consist of several assistants, (a)
supervisor(s) and a responsible manager. In addition, most audit firms are separated in an
advisory and in an audit division. The audit manager is the one who signs the audit report and is
responsible for providing the right opinion. Because his job and compensation depends on his
performance (bonus plan hypothesis) a manager in an audit firm has his own career path and
wants to generate as much money for the firm as possible. On the other hand he wants to
diminish litigation risk on his jobs. In the last year before the rotation he is no longer able to
succeed with his audit job (litigation cost hypothesis). His ability to generate revenue with his
audit job ends and he has a cool off period of four years (Commission, 2004). He only cares
about diminishing the litigation for the audit firm in the last year. Argued based on a PAT
perspective, mandatory auditor rotation will cause more conservatism in the last year before the
22
rotation, due to the absence of maintaining the client. This prediction based on PAT shows many
similarities with the predictions based on the Agency Theory. The before signaled predictions
based on the Agency theory and on the PAT are the basis to derive the hypotheses in chapter
five.
2.7 Market Based Accounting Research
This thesis derives mainly conclusions based on the relation between the figures in the annual
financial statements and the stock returns. All three models derive conclusions based on this
relation. This kind of research is called Market Based Accounting Research (MBAR) and has its
origin in the articles of Ball & Brown (1968) and Beaver (1968). Basis of this type of research is
the assumption about the reaction of the stock market on information. This assumption is called
the Efficient Market Hypothesis (EMH) and is introduced in 1970 by Fama (1970). The
hypothesis assumes that the stock prices reflect all the public information, in addition about
future trends and expectations, about the company and the market. A financial trader is not able
to realize disproportional gains on a structural basis, without a risk-adjustment (Fama, 1970).
Three forms of the efficient markets exist: the weak form, the semi-strong form and the strong
form. In the weak form only past public information in the stock price is reflected. In the semistrong form all public information from the past and the future is reflected in the stock price and
in the strong form even insider information is directly in the stock price reflected. Because
certain companies, with comparable characteristics, were found that outperform other companies
structurally, this hypothesis is no longer accepted as in which way the stock markets are
functioning (Rosenberg, Reid, & Lanstein, 1985). But still, the EMH is accepted as a
simplification of in which way the stock markets are functioning. It is only necessary to exercise
caution by drawing conclusions when certain relations between accounting figures and stock
returns seems evident and try to exclude concurring explanations for significant relations.
2.8 Summary
In this chapter the background of the mandatory auditor rotation is presented. First the comments
of the mandatory rotation in the US before the implementation of SOX were presented. Because
of the drastic consequences for the audit market and the influence on the audit costs is decided
not to implement the mandatory audit rotation. In paragraph 2.2 the recent comments in Europe
and in the Netherlands have been presented. In the Netherlands a law is implemented which
enforces all public interest entities to rotate every eight years and in the European Union they
23
postponed decisions about this topic. In paragraph 2.3 prior empirical literature on the topic of
the audit tenure is stated. In paragraph 2.4 the concept of the use of conservatism is commented.
Which kinds of conservatism exist and which ones are subject of study in this thesis. In
paragraphs 2.5 and 2.6 the Agency Theory and the Positive accounting theory are explained
respectively and predictions based on these theories are formulated. In later chapters to these
theories will be referred. This thesis is a Market Based Accounting study. This kind of research
derives conclusions based on the relation between the accounting figures and the stock returns.
The limitations of this kind of research are commented and these limitations force to exercise
caution with drawing conclusions.
The next chapter presents models to measure the use of conservatism.
24
3. Models to measure the use of conservatism
The purpose of this chapter is to answer the second sub-question: Which models in prior
research are used to measure the use of conservatism?
The reasoning behind these models in this chapter is briefly commented and the empirical
findings will be presented in chapter four. Besides that, this chapter explains the different kinds
of the use of conservatism, as presented in paragraph 2.4, researched by the models. The models
used in the studies presented in this chapter are the most important models. Almost all authors
used one or more of the models presented here. The models presented in this chapter are directly
relevant for the research design in chapter 6.
3.1 Basu (1997)
Theory and expectations
Basu’s (1997) definition of conservatism is commented in prior chapters. This paragraph is used,
solely to present his predictions and theory.
The first prediction, of Basu (1997) is that a difference in timeliness exists on the published
earnings between good news and bad news. Bad news and good news are represented by
unexpected annual stock returns. The first prediction of Basu (1997) concerns the conditional
earnings conservatism. Because it is event driven conservatism, captured by the change in the
stock returns this is conditional. Because the influence of these events on the published earnings
is investigated, this is earnings conservatism. The second prediction by the author is that good
news is more persistent than bad news. This prediction is derived from the conservatism concept,
that bad news is taken promptly and good news is taken gradually. The third prediction of Basu
(1997) is that the abnormal return per dollar of the unexpected earnings is smaller for bad
earnings news, than for good earnings news. When bad developments in the company exist, the
influence on the future earnings is less persistent than at the moment of the good news.
Consequently, compared to negative earnings the stock price reaction is stronger at the moment
of positive earnings, in case of an equal amount.
Model
To test the formulated predictions, Basu (1997) used a reverse regression, with the published
earnings as the dependent variable and the unexpected annual stock returns are the independent
variable, as an indication for good and bad news. The model is stated as follows:
25
EPSit/Pi,t-1 = α0 + α1DRit + β0Rit + β1DRit*Rit + εit
Where,
EPSit = earnings per share of firm i in fiscal year t;
Pi,t-1 = price per share at the beginning of the fiscal year;
Rit = return of firm i over the twelve months beginning nine months prior to
the end of fiscal year t;
DRit = dummy variable set equal to 1 if Rit is negative and 0 otherwise
β1 captures the influence of bad news on earnings. When in the company conservative reporting
is present, this variable need to be significant, which indicates that bad news has a greater
influence on the published earnings than good news.
To determine if the use of conservatism is only present in earnings and not in cash flows he
performs the same test with cash flows of operations (CFO) and cash flows of operations and
investments (CFOI) as dependent variable. The value of the next ratio (β0+β1)/ β0, for the three
different dependent variables could indicate if only the use conservatism in the published
earnings exists and not in the cash flows. The value of this ratio needs to be significantly higher
in the test with the published earnings as dependent variable than in the cash flow tests.
This model is the same as the one used by Givoly and Hayn (2000), for finding asymmetry in
timeliness between good and bad news in the published earnings.
3.2 Givoly and Hayn (2000)
Givoly and Hayn (2000) used different methods to identify, both the use of balance sheet and
earnings conservatism. In their second chapter Givoly and Hayn explain the different methods
and the reason why these methods are an indication for the use of conservatism. The ideas
behind the methods are briefly commented and are operationalized in depth in chapter four.
Accumulation of operating accruals
Accruals tend to reverse: In one year the published earnings are higher than the cash flows and in
the next year the expectation would be that the cash flows are higher than the published earnings.
Based on this logic the expectation is that, at firms in a steady state, the cumulative amount of
net income before depreciation and amortization would converge with the cash flow from
26
operations. A consistent predominance of negative accruals across firms over a long time period
could be an indication of the use of conservatism. An accumulation of negative accruals would
indicate that a shift exists in the use of conservatism over time (Givoly & Hayn, 2000). The
model to determine the level of the use of conservatism is the rate and level of the negative
accrual accumulation. Referred to the different kinds of conservatism presented in chapter 2, this
model is earnings conservatism. This conservatism could have both forms, conditional and
unconditional.
Asymmetry in timeliness of bad news and good news in the published earnings
Conservatism is described as an earlier recognition of bad news in the published earnings than
good news. In this method stock returns are used as an independent variable reflecting the news.
The correlation between the negative stock returns (bad news) and the published earnings is
expected to be higher than the correlation between the positive stock returns (good news) and the
published earnings. The researchers use, next to a variable for return, a dummy variable to
perform a test with distinction between good news and bad news. This method has the major
limitation that stock returns are used as a proxy for the news content. Next the regression model
used by the authors to determine the asymmetry in the timeliness of good and bad news in
published earnings is presented:
EPSit/Pi,t-1 = α0 + α1DRit + β0Rit + β1DRit*Rit + εit
Where
EPSit = earnings per share of firm i in fiscal year t;
Pi,t-1 = price per share at the beginning of the fiscal year;
Rit = return of firm i over the twelve months beginning nine months prior to the end of fiscal year
t;
DRit = dummy variable set equal to 1 if Rit is negative and 0 otherwise
With this model the next conservatism characteristics can be captured (Givoly & Hayn, 2000):
-
The incremental response to bad news relative to good news, captured by β1, under
conservative reporting β1 is expected to be positive.
27
-
The relative sensitivity of the published earnings to bad news compared with their sensitivity
to good news, measured with the ratio (β0+β1)/ β0, under conservative reporting. This ratio
is expected to be greater than 1.
-
The relative explanatory power of the regression in periods of bad news and good news,
assessed by the ratio of R² in the bad news periods to the R² in the good news periods. Under
conservative reporting this ratio is expected to be higher than 1.
-
The average downward bias in the earnings-to-price ratio due to the use of conservatism.
Skewness of the published earnings
Related to the asymmetry method is the skewness method. Because bad news is immediately
recognized in the published earnings and good news is more gradually recognized in the
published earnings, a negatively skewed earnings distribution could be expected. With this
method it is tested whether or not the published earnings distribution is significantly skewed to
the left (negative). To test the skewness the next model is used:
𝑛
[𝐸 𝑥𝑡 − μ 3]/σ3
𝑦=
𝑡=1
Where:
y = skewness
E = expectation
x = ROA (Net income/total assets) or CFO/Total assets (CFO = cash flow
from operating activities)
μ = The mean of x
σ = The standard deviation of x
n = number of observations
Because it tests the skewness of earnings in all years, without necessarily a prior event, this
model captures the use of conditional and unconditional earnings conservatism.
Normally the square is used in determining the variance from the mean (or skewness). Because
there are negative earnings in the data as well, that become positive when they get squared, a
three is used to capture negative skewness as well with this model.
28
Market-to-book ratio
The method which tests the most formal definition of the use conservatism is the market-to-book
ratio: Choose the lowest value when two or more possibilities exist. When the market-to-book
value is higher than 1 this indicates that the market value (on the stock market) is higher than the
intrinsic value of the firm as stated in the balance sheet. Because that will indicate if a difference
in the use of conservatism exists compared to prior years, particularly, it is essential to
investigate the change of this ratio over time. This model tests the use of unconditional balance
sheet conservatism. Because the book value of the company is compared to the market value of
the company and unconditional because not necessarily a prior event had to occur that caused the
use of conservatism.
3.3 Summary
In this chapter the relevant models are presented that are used by the most important authors on
the topic of the use of conservatism. The article of Basu (1997) commented the asymmetry in
timeliness of good and bad news in the published earnings. This model is one of the four
methods used by Givoly and Hayn (2000). Other methods they used were the accumulation of
the accruals, the skewness in the published earnings and the market-to-book ratio. The empirical
findings of these studies will be presented in the next chapter. These four models are used by
most authors this is an indication of their usefulness to investigate the use of conservatism. The
sample and the purpose of this study meet the requirements of the models; consequently these
models are used in this thesis. This will be commented in depth in chapter six, which refers to the
research design, but first the empirical findings of the relevant articles will be commented in the
next chapter.
29
4. Empirical findings in literature
The purpose of this chapter is to answer the third sub-question: What are the results in prior
research on conservatism and in which does this research contribute to answer the research
question? The relevant models for this thesis already have been presented in the prior chapter. In
other articles to determine the use of conservatism other methods are used. Because the methods
are not directly relevant for this thesis but the findings are, these methods and findings will be
presented in this chapter. Other authors perform already research concerning the use of
conservatism and to prevent from redoing their work the topics they researched will be
presented. This chapter is the basis for the hypothesis in chapter five. This chapter is build up as
follows: First the experimental study of Wang & Tuttle will be commented, than two related
studies about audit quality is part of discussion (Johnson et al. (2002) and Myers et al (2003))
and after that the conservatism archival studies will be presented in chronologic sequence.
4.1 Balance sheet conservatism in experimental setting, Wang & Tuttle (2009)
Wang and Tuttle (2009) in their research formulated the next three hypotheses:
H1
Mandatory rotation affects the negotiation strategies used by auditors.
H2
Mandatory rotation affects the negotiation strategies used by clients.
H3
Mandatory rotation creates less cooperation by auditors in negotiation.
To test these hypotheses, Wang and Tuttle (2009) performed an experimental research, in which
they created a setting for the participants with mandatory audit rotation and one without. The
participants were graduate students of an economic course and negotiated in three rounds. The
pay-offs created in the experiment were comparable to the pay-offs of an auditor and a client
when they negotiate about a certain balance sheet value of an asset. The authors argue caused by
their findings that in a setting with mandatory audit rotation a greater frequency exists of noncooperative negotiation strategies from the side of the auditor. They argued that this has the next
three reasons:
-
The future pay-offs of the relationship diminish because of the shorter time-span of the
relationship;
30
-
No reputational damage in the last year before the auditor rotation exists when the auditor
ends the relationship;
-
A situation exists in which clients are seeking for an auditor; this will lower the concern
of the auditor for the audit relation drastically.
The first explanation is supported by DeFond and Subramanyam(1998), who argued that caused
by a shorter time-span of the relation, the auditor is less willing to follow up assertions of
management about the value of the balance sheet items. However, the second explanation is not
in conformity with the findings of Comunale and Sexton (2005) who argued that with mandatory
auditor rotation the ability to attract new clients (reputation) is more important than the ability to
retain existing clients.
Because his performance is every year calculated based on these figures in the experiment of
Wang & Tuttle (2009) the client is always concerned about the outcome of the negotiations with
his auditor. Because it will end anyway, the client as well does not suffer from reputational
damage to their shareholders when the relationship comes to an end. The results for the client are
not as strong as the results for the auditor, but the client is becoming less cooperative as well in a
mandatory rotation setting. In addition, the negotiations are resulting more frequently in an
impasse when mandatory auditor rotation exists.
In the study of Wang & Tuttle (2009), the balance sheet asset values proposed by the auditor are
the values reported on in the financial statements, when the negotiation ends in an impasse.
Because the pay-off of the client is more favored by a higher value, these values are always
lower than the proposed value of the client. Experimental research on the topic of the use of
conservatism in combination with mandatory audit rotation is performed in this study of Wang &
Tuttle (2009), but is restricted by the boundaries of experiments.
A critical remark needs to be signaled. Due to the fact that this is experimental and not archival
research, it could lack external and construct validity. The pay-offs of this study were
comparable to a mandatory rotation setting, but more factors than monetary exist, that has to be
taken into consideration.
The assumptions and incentives created in this research are quite simplistic. The authors argue
that no reputational damage exists when the auditor act non-cooperative in the last year of the
relationship. Maybe no reputational damage in an experimental setting exists, as the one used by
31
the authors, but in real life there is as the one presented in chapter 2.5 related to other services
the audit firm wants to provide in the future.
4.2 The influence of the audit tenure on the audit quality, Johnson et al. (2002) and
Myers et al. (2003)
The results of Myers et al. (2003) indicate that the dispersion of the total and the discretionary
accruals is lower when the audit tenure is longer. The findings indicate that the auditor places
more constraints on income increasing and income decreasing accruals when tenures are longer
than in case of short tenures. Supported by their findings the authors argue that a longer tenure
does not cause lower audit quality. Arguments of the proponents of the mandatory auditor
rotation are refuted with this study. Because the authors use accruals as a measure of the audit
quality this research is relevant. One of the used measures of the use of conservatism is the
accumulation of (non)operating accruals. This research indicates the longer the relation between
the auditor and the client lasts less unexpected accruals are presented.
The findings of Johnson et al. (2002) show, that a short tenure has significant more unexpected
accruals than an average tenure. The findings for a long tenure do not show any significant
differences. Additionally Johnson et al. (2002) investigated the persistence of accruals on the
next period published earnings. A short tenure show a significantly lower persistence of accruals
with next period published earnings compared to longer tenures. Comparable to the before
signalled research of Myers, Myers & Omer (2003), no supporting evidence exists for arguments
of proponents of mandatory auditor rotation that a longer tenure will lower the audit quality.
However, in the research the opposite is found that the start of the tenure (2-3 years) creates a
significant lower audit quality (Johnson, Khurana, & Reynolds, 2002). These findings are
relevant for the predictions about the use of conservatism in the research to be performed.
Based on the two in this section presented studies, no support exists for the expectation that the
quality of the audit will increase when the auditor is rotated once a while, as argued by
proponents of the mandatory auditor rotation. These two studies indicate a positive relation
between a longer relation and the predictive quality of accruals. Besides that this studies are
performed in the US and not in the European Union, nothing is stated about the quality and the
accumulation of accruals (conservatism) in the last year of an auditor client relation.
32
4.3 Balance sheet conservatism in Europe, Joos & Lang (1994)
Dated research on the topic of balance sheet conservatism is performed by Joos & Lang (1994).
They performed their research in Germany, France and in the UK and expected to be different
kinds of conservatism between the three selected countries, caused by the differences in the
GAAP’s between these countries. They found that the book-to-market value is lower than one in
all countries for the period 1982 up to and included 1990. Their statistical approach was
univariate analysis, price regressions and return regressions. Their total observations were 8,000,
equally spread over the timeframe. They found a difference between the three countries. Balance
sheet conservatism was significantly greatest in Germany compared to the UK and France. In
addition, balance sheet conservatism in all continental countries on average was significantly
greater than the use of balance sheet conservatism in the UK (Joos & Lang, 1994). The authors
argue that this difference is influenced by the financial structure of the companies in these
regions. In continental Europe financing is dominantly performed by financial institutions. They
want an understatement of the book value of the shareholders' equity to assess the borrowing
capacity of the firm from a pessimistic perspective. Because this difference in financial structure
is part of the economic reality for a long time, differences are implemented in the accounting
measurements as well.
The research of Joos & Lang (1994) concerning this research is valuable in different ways. First,
the comparability of the financial structure of German and French firms is tested. They are
highly comparable.
In addition, the method used to determine the balance sheet conservatism (book-to-market ratio)
is credible for this purpose.
However, the research of Joos & Lang (1994) is a bit outdated. The integration in the European
Union caused convergence between the different European accounting policies and financial
structuring. The findings based on the years 1982 up to and included 1990 are no longer relevant
for the situation nowadays.
33
4.4 Difference in timeliness of bad news and good news in Earnings: Earnings
conservatism, Basu (1997)
One of the basic papers about conservatism is the paper of Basu (1997). He investigated the
differential timeliness of good news and bad news in earnings. He expected a more timely
reaction of bad news in published earnings than good news in published earnings. In addition he
expected that positive earnings are more persistent than negative earnings. This second
prediction he used is not directly relevant for this thesis and will be no longer referred to.
The first prediction related to with his first expectation is that the slope coefficient and the R² of
the annual earnings on the stock returns are higher for negative returns than for positive returns.
This is expected because in conservative reporting unrealized losses are taken more promptly
than unrealized gains, and consequently has a higher predictive power on the published earnings.
This is tested with the model presented in the prior chapter. The sample is separated in two sub
samples, one with positive returns and one with negative returns. The explanatory power of
negative returns is 6,64% and the explanatory power of the positive returns is 2,09%. In addition,
the slope of the negative returns is larger than the slope of the positive returns. The influence of
the negative returns is four times larger than the influence of the positive returns on the published
earnings. Consequently, both predictions are confirmed
A second research he performed is the asymmetry in timeliness of the cash flows and the
published earnings to bad news and to good news. To test this, he used the model presented in
chapter 3. Comparable researches are performed, with cash flow from operations (CFO) and cash
flow from operations and investments (CFOI) as dependent variable. The difference in timeliness
between good and bad news is less severe when CFO is the dependent variable than when CFOI
is the dependent variable. In addition, the difference in timeliness between good and bad news is
less severe when CFOI is the dependent variable than when the earnings before extra-ordinary
items are the dependent variable. This indicates that the use of conservatism is visible in the
published earnings and not in the cash flows. This test, with different dependent variables, is
performed to determine the reliability of the found conservatism in the published earnings. Cash
flows are persistent over the years and the accruals are used to report conservative (Basu, 1997).
34
The third prediction is that negative earnings reverse more often than positive earnings. Findings
which evidenced this mean-reverting tendency are performed by prior researchers. To determine
if this mean reverting tendency is present as well in the sample the author used the next model:
∆Xit/Pit- 1 = αo + α1D + βo∆Xit- 1/Pit- 2+β1D*∆Xit- 1/Pit,
Where, Xit is earnings of firm i in fiscal year t, ∆Xit is the change in earnings for firm i for fiscal
year t over fiscal year t - 1. Pi-1 is the price per share at the close of fiscal year t - 1. D is a
dummy variable equal to 1 if ∆Xit- 1/Pit- 2 is < 0 (bad news firms) and 0 otherwise (good news
firms).
The statistical tests show that the slope dummies for the positive published earnings are not
significant different from zero (-0.040), but the slope dummy in case of negative published
earnings are significant different from zero (-0.694). This indicates that negative earnings in the
prior period reverts significantly more often to positive earnings in the next period. The
prediction of the author is stimulated by the statistical evidence.
Summarized, Basu (1997) gathered evidence that the published earnings are conservative. The
timeliness of bad news in the published earnings is six times higher than the good news. The
difference is statistically significant. Additionally, by testing if these differences occur as well on
a CFO or CFOI level (what was not the case), Basu found that the use of conservatism is
performed by use of accruals.
In addition, another characteristic of the use of conservatism is tested as well. Because losses are
anticipated and gains are taken gradually, the expectation is that losses are more mean reverting
than gains. Evidence about this difference in mean reverting is found with the statistical tests.
Basu (1997) concluded that the use of conservatism is present in the published earnings.
4.5 Development of earnings and balance sheet conservatism in the US, Givoly &
Hayn (2000)
Givoly & Hayn (2000) studied the use of conservatism in the US over a timeframe of 40 years.
They did not formulate a specific hypothesis in their research, but investigate the change in the
use of conservatism over the time frame and expect that there will be changes in this
conservatism. To perform their tests Givoly & Hayn (2000) used the Compustat database. This
database contains information from 1950 up to and included 1998 of American companies.
35
Because these companies are bound by some special regulations, they exclude utility and
financial companies. Due to the fact that the database only contains 896 firms in 1950 and the
late years are represented by 9,000 firms, they used a stable sample of firms that were present in
all the years, next to their full sample test with all the firm observations. The background and the
models used to perform the tests are already presented in chapter three before. Underneath the
empirical findings of the study are presented.
Accumulation of non-operating accruals
The authors first analyzed their data. They saw a decline in the published profitability over time.
This decline could be caused by a change in the reporting or by a change in the real economic
performance. When a change in real economic performance exists, the cash flows should be
affected as well. This is not the case. Cash flows are constant overtime that indicates a wider use
of accruals. In the period before 1982 the aggregate cumulative published earnings exceed the
aggregate cumulative cash flows and in the period thereafter the reverse was the case. This
indicates that before 1982 the sample firms generate net positive accruals and after that year the
sample firms generate negative accruals. The cash flows are systematically above the reported
earnings in the period after 1982.
The authors distinguished operating and non-operating accruals. Operating accruals are the
change in accruals related to the day to day business of the firm (working capital changes). Nonoperating accruals are the accruals that remain, after deducting depreciation and operating
accruals from the total accruals. The remainder consists of bad debt provisions, restructuring
charges, changes in estimates, gains or losses on the sale of assets and asset write-downs.
Creation of these accruals is bounded by regulation, but compared to operating accruals more
management discretion with this kind of accruals exists. The accumulation of the non-operating
accruals is significantly getting more negative when time evolves. This indicates an increase in
the use of earnings conservatism.
Givoly & Hayn (2000) provide some other explanations than the use of conservatism what could
cause the increase in the accumulation of the non-operating accruals.
Their first explanation is the increase in restructuring charges that lowers the reported earnings.
This is a phenomenon which is detected in recent decades parallel to the increase in the
accumulation of the negative accruals. To examine if this is the cause of negative accruals, the
36
authors eliminate this restructuring charges from the published earnings and still detect an
increase in the negative non-operating accruals.
Their second alternative explanation is that the drop in the profitability is caused by waves of
mergers and acquisitions (M&A). The authors refer to research of Davis (1990), who stated that
in recent times another accounting method is used for M&A, the purchase method. This method
dampens the profitability (and cause negative accruals) due to an increase in the depreciation and
the amortization costs. Besides that, M&A activities are highly financed with debts. This causes
a lower profit due to interest charges. The authors performed their analysis again with
organizations which are not engaged in M&A activities during the test period. The findings are
not distinguishable from the findings of the full sample. In addition, the earnings before
depreciation and amortization show a same pattern as the earnings after these charges.
A third explanation for the lower earnings and the increase in the negative non-operating
accruals could be the retirement expenses that companies are recently obliged to create on a
more timely basis due to recent accounting standards. To examine this alternative explanation the
authors exclude these expenses and saw a similar trend in the accumulation of the negative
accruals when the expense items in the sample are included.
The fourth and last alternative explanation is a more technical one. Due to inflation and growth
the accumulation of the accruals could be higher over time. To control for growth in sample
firms, in the used tests earnings and cash flows are deflated by total assets. The authors argue
that this control mechanism not fully captures the cause of the increase in the negative accruals.
This phenomenon is more related to sales or inflation. In the later sub-periods, from 1980
onwards, the accumulation of the negative accruals is higher than in the earlier sub-periods.
However, the growth in sales and in inflation is higher in the earlier sub-periods. The expectation
is that the reverse would be the case. The authors perform comparative tests with the alternative
deflators and detect comparable results as the results of their prior method.
The alternative explanations are not consistent with the increase in the accumulation of the
negative accruals.
37
Asymmetry in timeliness of good news and bad news in earnings
The regression, presented in chapter three, is tested to detect the difference in timeliness of good
news and bad news in the published earnings. For readers' convenience the model is presented as
well:
EPSit/Pi,t-1 = α0 + α1DRit + β0Rit + β1DRit * Rit + εit
Where
EPSit = earnings per share of firm i in fiscal year t;
Pi,t-1 = price per share at the beginning of the fiscal year;
Rit = return of firm i over the twelve months beginning nine months prior to the
end of fiscal year t;
DRit = dummy variable set equal to 1 if Rit is negative and 0 otherwise
β1 is positive and significant for the whole period (1950 up to and included 1998). This indicates
that the influence of a negative stock price return (or bad news) has a significant effect on the
published earnings. Bad news affects the published earnings to a higher extend than good news
for all the sub-periods and the influence is increasing over time. Evidence is found, that bad news
is translated more promptly in the published earnings than good news and that the use of
conservatism overtime is increasing.
Besides that (β0+β1)/ β0 , which assesses the sensitivity of the published earnings to bad news
relatively to good news, shows a similar pattern. The published earnings are more sensitive to
bad news than to good news, indicated by the value of this measure that concerning all the subperiods is above 1. In addition, the value is increasing over time. In the earliest sub-period (1950
up to and included 1955) this value was slightly above 1 (1,73) and in the latest sub-period (1991
up to and included 1998) the value was 25.
Additionally, the R² of the sample with only EPSit/Pi,t-1 = α0 + β0Rit has a lower value than the R²
of the sample with a dummy variable inserted EPSit/Pi,t-1 = α0 + α1DRit + β0Rit + β1DRit*Rit, this
indicates a difference in the published earnings response with good news and bad news.
38
Skewness of earnings
As already signaled, in a conservative setting losses are taken immediately and favorable events
are taken gradually at the moment of recognition. This assumption indicates that earnings are
negatively skewed and because they result from real cash inflows and outflows of the
organization cash flows are not influenced. The skewness is measured with E(x-µ)³/σ³, where x
is the return on assets (or CFO/ assets) and µ and σ are the mean and the standard deviation of
the ROA (or the CFO/ assets). The authors plotted their findings in a diagram and the skewness
of published earnings is visible, especially in the late sub-period of their sample (1980 up to and
included 1998). In the same late period there was no negative skewness of cash flows. In
addition, with this method the use of conservatism in their findings was visible. The distinctive
characteristic of this model is that stock prices are no variable. This characteristic increases the
persuasiveness if the findings of the different tests are comparable. Besides that, the sample can
extend and include non-stock exchange quoted firms as well. Because only large stock exchange
quoted firms are included due to the assumption that the auditor is aware of his rotation before he
is performing the final audit, this test could not be used in this thesis.
Market-to-book ratio
The last test the authors performed to examine the use of conservatism in the reported figures is
the market to book ratio. Because, the market value of the organization is the present value of the
expected cash flows, a lower book value indicates the use of conservative accounting. When the
difference between the market value and the book value is larger this could indicate that the
reporting is more conservative.
The researchers aggregated the companies' market capitalization and divided with aggregated
book values. The line that is been visible is a U-shaped line. With A high market to book ratio in
1950, a decline till 1980 and after that a steady increase till 1998. This market-to-book ratio
could be explained by a change in the expectations about the future cash flows and not only by
the use of conservative reporting. That is why the authors divided the sample in five different
subgroups, selected based on their growth in the five preceding years. The median market-tobook ratio for the early sub-period (1968 up to and included 1980) was 1,30 and the median
market-to-book ratio for the late sub-period (1981 up to and included 1998) was 1,67. In
addition, based on this test results the use of conservatism is increasing.
39
The four tests overall indicate an increase in the reported conservatism, especially in the last two
decades on the twentieth century. All tests have some minor limitations. The authors examined
competing explanations for the decrease in the relation between the published earnings and the
cash flows, however these explanations were not sufficiently explanatory for determining the
decrease in the relation.
The use of conservatism needs to be the driving power behind this diminishing relation.
4.6 Empirical findings of Conservatism in Europe, Garcia Lara & Mora (2004)
Garcia Lara & Mora (2004) argue that managers and auditors, when reporting conservative,
prefer the lowest value of earnings and assets to report, when more possibilities are equal likely.
Assets are reported for the lowest possible value and liabilities for the highest possible value.
This implies a consistent understatement of the shareholders’ value and of the reported earnings.
In their study Garcia Lara & Mora (2004) tested the use of conservatism in eight different
European countries and investigated if a difference exists in kinds of conservatism used in the
different countries. They expect in the so-called Code-law countries more balance sheet
conservatism than in the common-law countries. Contrarily they expect a higher degree of the
use of earnings conservatism in the common-law countries compared to the continental
countries. A special characteristic the authors in their study implement was the interaction
between the use of earnings conservatism and the use of balance sheet conservatism. When the
use of balance sheet conservatism is present to a relatively large extend, a lower use of earnings
conservatism is expected and vice versa. This implementation of an interaction effect could be
qualified as a continuation and an addition to the results of Joos & Lang (1994)
Balance sheet conservatism in Europe
The authors first tested if the use of balance sheet conservatism in all the selected countries
exists. Concerning examining this they used the market-to-book ratio comparable to the one used
by Givoly & Hayn (2000). Garcia Lara & Mora (2004) found that the use of balance sheet
conservatism exists in all of the eight selected countries, indicated by a ratio higher than 1.
In addition the authors tested their second hypothesis; compared to common law countries in
code law countries a higher degree of the use of balance sheet conservatism exists. Because
regulation in the code law countries would automatically lead to the understatement of the assets
40
that was their expectation. The results of their tests indicate that the market to book value is
significantly greater in all the continental European countries compared to the UK, except for
Italy. When investigating the aggregated sample of all the continental firms compared to the UK
firms, the value of this measure is as well significant higher.
Earnings conservatism in Europe
Like prior studies, for example the one performed by Givoly & Hayn (2000) and Basu (1997),
earnings are more affected by bad news than by good news. The hypothesis in this study is that
the use of earnings conservatism is present in all the selected European countries. To test this
they used the model created by Basu (1997), which is the same as the one used by Givoly &
Hayn (2005). The hypothesis is true. In all the selected European countries a faster recognition
exists of bad news in the published earnings than the good news. When all the continental
countries are pooled this faster recognition of bad news with respect to good news in addition is
statistically significant.
The authors expect to detect the use of higher earnings conservatism in common-law countries
with respect to code law countries. They created a comparative model with a dummy for all the
selected countries. When the UK is used as benchmark they expect all other countries to have
negative coefficients (because they use lower earnings conservatism). Only Germany has
significantly lower earnings conservatism than the UK.
To test if a difference exists in the composition of the sample in each selected country, several
sensitivity tests are performed. To eliminate these scale effects which could influence the extent
of the use of balance sheet or the use of earnings conservatism the composition differences
between the different countries are mitigated by performing tests with comparable firms in each
country. These tests show that more use of earnings conservatism exists at smaller firms. This
finding had no effect on the results of the tests.
As predicted by the authors’ overall can be stated that the use of balance sheet conservatism is
statistically higher in the selected code law countries. The use of earnings conservatism is
statistically higher in the UK than in Germany. Compared to the other European countries no
statistical difference is visible with the UK.
This study is nowadays less relevant than it was a few years ago. Because the accounting
standards enforce the use of conservative accounting, the use of balance sheet conservatism is
41
expected to be larger in continental Europe. However, since the stock exchange quoted
companies in the European Union use mandatorily IFRS in their consolidated annual financial
statements, these differences between code law and common law countries are expected to
diminish. This is caused because IFRS has more emphasis on the fair value.
4.7 Earnings conservatism with different auditor tenures, Kramer et al. (2011)
The model of Basu (1997) is used to determine the use of conservatism in the published earnings
with different auditor tenures. In the study the use of conservatism is used as a proxy for the
audit quality. The results find that the influence of bad news on the published earnings is much
larger than the influence of good news which indicates the use of conservatism (Kramer,
Georgakopoulos, Sotiropoulos, & Vasileiou, 2011). The regression is performed with a dummy
for firms in their first year after the rotation. In this regression a higher R-squared is presented
compared to the regression without a dummy for the first year of the relation that provides some
initial evidence that a higher level of the use of conservatism in the reported earnings exists in
the first year after the rotation.
Because the test of Basu (1997) is used to determine the use of conservatism in the case of the
rotation of the auditor, this study is relevant for the thesis. This test is used by many other
authors as well and is considered as an appropriate measure to capture this phenomenon. In
addition, the basics of the approach used by Kramer et al. (2011) will be used in this thesis, with
an adjustment in the sample of the firms. In addition, the research showed that it is necessary to
control for qualified opinions as the reason for an auditor switch. The presence of this opinion
could be the reason for the switch and the presence of this opinion harms the comparability of
the findings with the total population.
4.8 Summary
In this chapter several empirical studies have been presented. The findings and the methods these
authors used are partly relevant for this thesis. The article of Joos & Lang (1994) investigated the
difference in the use of conservatism between different European countries. The authors only
investigated the use of balance sheet conservatism and detect significant differences between the
magnitudes of the use of conservatism in these different selected countries. In Germany the use
of balance sheet conservatism was significantly greater than in the other selected continental
countries and especially greater compared to the UK. These findings are in conformity with the
later findings of Garcia Lara & Mora (2004). They investigated the difference between eight
42
European countries and determined that the use of balance sheet conservatism in continental
Europe was significantly larger than in the UK. The use of earnings conservatism was not
significantly larger in the UK than in other European countries, except for Germany. These
studies are performed before the implementation of IFRS in 2005. With IFRS the standards are
uniform and the used conservatism levels are expected to congruence between the countries in
the European Union.
To capture the change in the level in the use of conservatism due to the change in the standards,
concerning this thesis it is wise to control for the implementation of IFRS in 2005.
The tests, used by most authors, to determine the use of conservatism are comparable. The use of
balance sheet conservatism is measured with the market-to-book ratio, introduced by Feltham &
Ohlson (1994), in most studies (Garcia Lara, 2004) (Givoly & Hayn, 2000). This method
compares the market capitalization of a firm with its book value. A value higher than one
indicates the use of conservatism.
The use of earnings conservatism is investigated in the studies by Basu (1997), Garcia Lara &
Mora (2004) and Givoly & Hayn (2000). The method introduced by Basu (1997), to detect the
difference in timeliness between good news and bad news on the published earnings, is used by
many authors afterwards. He found the use of conservatism in the published earnings and
determined that the use of conservatism is reached by accumulation of the accruals. Because
findings of these tests are in conformity with prior conservative measures and excluded major
concurring explanations, this test is qualified as appropriate. Consequently this measure will be
used in this thesis.
In addition, because to determine the use of earnings conservatism two additional tests are
introduced the article by Givoly & Hayn is valuable. The first test is the accumulation of the nonoperating accruals. This is nothing more than the difference between the published earnings and
the cash flows with a deduction from the changes in the working capital. This is a basic test that
can be used in this thesis. Besides that, they introduced the skewness in the earnings as an
additional test of the use of earnings conservatism. In case of conservatism, earnings are
negatively skewed.
The predictions the relevant authors formulated are focused on the evolution of the use of
conservatism during time series or between countries. This thesis focuses more on the
comparison between firms where a condition is met (last year of the auditor client relation) and
43
firms where this condition is not met. For formulation of the hypothesis especially the article of
Wang & Tuttle is relevant (see chapter 5) and for statistical models as presented in the research
design (chapter 6) all other commented studies of this chapter are relevant.
44
5. Hypothesis
This chapter will provide the answer to the following sub-question: Which hypothesis is
formulated based on the research question and prior literature to answer the research question?
In the prior chapter the empirical literature is presented. Based on this literature certain topics are
no longer relevant to investigate. Especially the relation between the audit tenure and the audit
quality and the relation between mandatory auditor rotation and the audit quality is thoroughly
investigated. On the other hand, certain findings in these studies add value to this thesis and
enable to formulate predictions. Purpose of this chapter is to formulate predictions, molded into a
hypothesis. In addition, the relation between the existing scientific literature and the prediction is
presented.
5.1 Hypothesis development
In this thesis will be examined if a different level of the use of conservatism exists in the last
year of the auditor-client relation, compared to prior years of the audit relation. Because
conservative accounting decisions lower the litigation risk for an auditor, empirical studies
suggest that auditors have a preference for the use of conservative accounting decisions (DeFond
& Subramanyam, 1998). Because their income is related to the reported profits and asset values,
the client favors most of the time a more non-conservative accounting policy (Wang & Tuttle,
2009). If the client becomes dissatisfied the auditor can lose the client and the related future
economic benefits, without mandatory rotation the auditor does not want to be too conservative
(Dopuch, King, & Schwartz, 2001). Because in the last year before the mandatory auditor
rotation, the incentive for the auditor to keep the client satisfied in order to gain future economic
benefits, disappears. These findings of Dopuch et al. (2001) are relevant for the prediction
formulated in the hypothesis. These empirical findings are in conformity with the agency theory.
The agent (auditor) is acting more conservative in the last year to favor his own interest. Because
a slightly dissatisfied client (principal) has no influence on his future pay-off, due to the reason
that he is no longer client for the coming years, the auditor has no short term loss when he
operates conservative. Besides that, he diminishes his litigation risk with approval of
conservative asset values in the balance sheet. Raiborn, Schorg & Massoud (2006) endorse this
tendency towards the use of conservatism with another reason. They stated that the assertions
and the balance values that are approved in the final year before the rotation need to be evaluated
45
by the new auditor in the next year. Aggressive accounting practices will be discovered and
errors perform by the auditor will be reported on (Raiborn, Schorg, & Massoud, 2006). To
prevent scandals with the new auditor, the auditor need to act critical in his last year.
Contrasting predictions are presented in the study by Comunale and Sexton (2005). In their
results they showed an indication that auditors in all periods are prudent with too conservative
accounting. Audit firms need to operate more customer minded. In a mandatory rotation setting
auditors need to attract new clients more frequently and they benefit from a good reputation in
the market. The ability of audit firms to attract new customers is more important than the fear for
litigation (Comunale & Sexton, 2005). Based on these findings the auditor will not change his
conservatism towards the client even not in the last year or maybe especially not in the last year.
These findings formulated by Comunale & Sexton (2005) are a bit conflicting with the
predictions based on the PAT and on the agency theory. The big four audit firms are divided in
an audit and an advisory division. This segregation causes that audit managers, responsible for
performing the audit job, have no direct incentive for keeping the client at the audit firm to sell in
future times advisory tasks. This advisory division has its own responsible managers and its own
revenue targets. Consequently the structure of audit firms diminishes the reputational argument
of the authors.
A directly relevant study is Wang & Tuttle (2009). This is one of the few studies which were
able to investigate the influence of the auditor rotation on the audit quality and the use of
conservatism in the last year before the rotation. They found experimental evidence that auditors
communicate more frequently their approval on less conservative values in years early in the
tenure of a mandatory rotation client than in the last year. The last year of an auditor-client
relation is characterized by the use of conservatism on the side of the auditor. He operates more
frequent non-cooperative. These findings are the main reason why the prediction of this thesis is
a higher level of the use of conservatism in the last year before the auditor rotation. This
prediction creates the next hypothesis.
46
H0:
In the last year before rotating the auditor, no difference exists in the degree of the use of
conservatism compared to previous years.
Ha:
In the last year before rotating the auditor, a higher degree of the use of conservatism exists,
compared to previous years.
The main hypothesis and the sub-hypotheses are formulated with the expectations of this thesis
incorporated. The null hypotheses of this thesis are that no effect is visible in the dataset. The
direction on the expected conservatism is formulated to create a closer knit with the theoretical
foundation and the expectations that are tested in this thesis.
Support for this hypothesis is found in the experimental findings of Wang & Tuttle (2009) and
Dopuch, King & Schwartz (2001) and in the normative research of Defond & Subramanyam
(1998) and Rayborn Schorg & Massoud (2006) as commented before.
For practical reasons, the hypothesis will be divided into two different sub-hypotheses. The first
one will focus on the level on the use of balance sheet conservatism in the last year before the
rotation and the second hypothesis will focus on the level of the use of earnings conservatism in
the last year.
H01:
In the last year before rotating the auditor, no difference exists in the degree of the use of
balance sheet conservatism compared to previous years.
Ha1:
In the last year before rotating the auditor, a higher degree of the use of balance sheet
conservatism exists, compared to previous years.
47
H02:
In the last year before rotating the auditor, no difference exists in the degree of the use of
earnings conservatism compared to previous years.
Ha2:
In the last year before rotating the auditor, a higher degree of the use of earnings conservatism
exists, compared to previous years.
This distinction is in conformity with the different models used in this thesis to determine the use
of conservatism, presented in the next chapter. The market-to-book ratio investigates the use of
balance sheet conservatism and the skewness of the published earnings and the asymmetric
timeliness of the published earnings investigate the use of earnings conservatism. These
hypotheses will be tested with the research design presented in the next chapter.
5.2 Summary
In this chapter the direct relevant studies and theories for formulating the hypotheses have been
presented. A tension in predictions exists about the level of the use of conservatism in the last
year before rotating of the auditor. The literature, both empirical and normative, suggests that the
tension toward more conservatism in the last year is stronger, than the tension to less
conservatism. That is why the alternative hypothesis is stated as follows: In the last year before
rotating the auditor, a higher degree of the use of conservatism exists, compared to previous
years.
The hypothesis is divided in two separate hypotheses, one investigating the use of balance sheet
conservatism and the other investigating the use of earnings conservatism. This distinction is in
conformity with the different models that will used to test the use of conservatism. The research
design presented in the next chapter is used to test the hypotheses.
48
6. Research design
In this chapter the research design will be presented. First the research method and the models
will be explained. What are the proxies for the economic events investigated in this thesis? In
this paragraph the statistical tests will be explained as well. Secondly, the sample will be
presented. Special attention exists for the selected countries and their characteristics. Thirdly the
method to retrieve the data will be presented. The databases containing the necessary data will be
signaled. The fourth and the fifth paragraph will be used to present the attainability and the
limitations relevant for this thesis.
6.1 Research method, model proxies and statistical analysis
In this thesis the most appropriate method to handle a large amount of data is an archival
research. The models of Givoly and Hayn (2000) are used to perform this archival research.
They distinguish their method in the next four different measures of the use of conservatism, the
‘accumulation of non-operating accruals’, ‘differential timeliness in the recognizing of bad and
good news in the published earnings’, ‘ the skewness of the published earnings distribution’ and
‘the market-to-book ratio’. These four measures are able to determine the level of the use of
conservatism. The first three measures are able to determine the level of the use of earnings
conservatism and the market-to-book-ratio is used for determining the level in the use of balance
sheet conservatism. The explanation for excluding the model: 'skewness of the published
earnings' is presented at the end of this paragraph.
Accumulation of operating accruals
The accumulation of operating accruals measures the relation between the published earnings
and the cash flows in a certain period and is an indication for the use of earnings conservatism.
The reasoning behind this model is already presented in paragraph 3.2 before.
In this thesis the relative amount of the negative accruals of the selected companies in the last
year of their relation with the auditor is compared with the relative amount of the negative
accruals in years before and after this final year. A higher presence of the negative accruals in
this last year indicates that compared to prior years firms report more conservative in the last
year.
49
Model proxies and measurement
As signaled in prior chapters the thesis uses the data of companies in the Netherlands, in
Belgium, and in Germany from 2003 up to and included 2012. Concerning this test the need
exists of the difference between the cash flows from operations (CFO) and the earnings before
depreciation and amortization or the operational profit. The difference between these two values
is the accumulation of the accruals. The choice for the operational profit above EBITDA is the
possible occurrence of non-operational results, like the sale of a division or the restructuring of
operations, which are part of the EBITDA but not of the CFO. In a steady state these two values
should converge with each other and no difference exists. When the use of conservatism is the
case the expectation is an accumulation of the accruals. Specific concerning this thesis the
expectation is an accumulation of accruals in the last year of the auditor-client relation. In the
statistical test a dummy will be add when it is the last year of the auditor-client relation.
The next regression model will be used:
(EBITDAt-CFO)= α0ti+β2D-ROTi+β3YEAR+ β4AFTER + εit
Where,
EBITDAti – CFOti is the published earnings before interest taxes depreciation and amortization
of company i in year t minus the cash flow from operations of company i in year t. This implies
the accumulation of the operating accruals.
YEAR is a time variable. The first year of sample firms has value one and so on.
D-ROTi is a dummy for the year the auditor is in its last year of auditing the client.
And AFTER, is a dummy variable with a value 1 for the years after the rotation.
When the variable β2 is significantly negative the second alternative sub-hypothesis (Ha2) is
confirmed. Then compared to other years a significant larger accumulation of the negative
accruals in the last year of the auditor-client relation exists, this indicates a higher level of the use
of earnings conservatism.
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Differential timeliness in recognizing bad and good news in the published earnings
The differential timeliness in recognizing bad and good news in the published earnings measures
the incremental response to bad news relative to good news. When the reporting of earnings is
conservative bad news is reported timelier in the published earnings than good news (Basu,
1997).
Model proxies and measurement
To determine this asymmetry in the earnings a cross-sectional regression analysis will be used
derived from Basu’s study (1997) and this is made appropriate to determine the influence of the
auditor rotation.
EPSit/Pi,t-1 = α0 + α1DRit + β0Rit + β1DRit*Rit + εit
Where,
EPSit = earnings per share of firm i in fiscal year t;
Pi,t-1 = price per share at the beginning of the fiscal year;
Rit = stock return of firm i over the twelve months beginning nine months prior to the
end of fiscal year t;
DRit = dummy variable set equal to 1 if Rit is negative and 0 otherwise
In this thesis the before signaled model is used to determine the change in the recognition of bad
news in the published earnings in the last year of an auditor-client relation, compared to years
earlier and later in the relation. The sample contains three different parts: One with firm year
observations of companies in the last year of the auditor client relation, one with the other firm
year observations before the last year of the auditor-client relation and one with firm year
observations after rotating the prior auditor. The results of the variables will be compared with
each other to test for significance. Besides that, this method allows to detect if some structural
changes in the use of conservatism exist, after the auditor is rotated or that the use of
conservatism levels have a tendency to go back to the levels before the rotation.
51
To determine if the use of conservatism exists Givoly and Hayn (2000) in their study created a
ratio. This ratio is calculated in the next way: (β0+β1)/β0. When this ratio is higher than one, the
use of conservatism is present, because bad news is recognized timelier than good news. These
ratios will be used for the three different samples as well.
The before presented test is a method to determine the use of earnings conservatism.
Market-to-book ratio
The market-to-book ratio is a balance sheet oriented proxy for the use of conservatism,
developed by Feltham and Olshon (1995). This definition views accounting as being
conservative if the expected value at time t of the excess of the market value over the book value
of the firm's equity at time t+τ is greater than zero as τ approaches infinity (Givoly & Hayn,
2000). This proxy uses the market-to-book ratio as the proxy for the use of conservatism and
when this ratio exceeds the value of 1, the use of conservatism is present, when the assumption
of efficient markets holds. Changes in the market-to-book ratio could be the consequence of over
or undervaluation of the company, but over or undervaluation cannot happen in an efficient
market (Fama, 1970).
Model proxies and measurement
In this thesis the market-to-book ratio of the selected firms in their last year of the auditor-client
relation will be compared with the market-to-book ratio of firms not in their last year.
Consequently, information about the market capitalization and the net book value of the sample
firms in the last year of the auditor-client relation needs to be compared with the values in years
before and after the auditors’ rotation year. The first alternative sub-hypothesis is confirmed
when the market-to-book ratio is significantly higher in the last year of the auditor-client relation
compared to the years before and after this last year.
Excluding skewness of earnings
In the article of Givoly & Hayn (2004) another model is used to determine the use of earnings
conservatism in the financial statements, the skewness in the published earnings. This model
uses the same variables as the accumulation of operating accruals model, cash flows from
operations and the published earnings. The findings of the two models will be highly comparable
52
and the implementation of this skewness of earnings model will not add a better interpretation of
the use of conservatism. Because this thesis does not have the goal to determine the quality of the
different models, is decided to exclude this model from the research design.
The advantage of this model above the others is that no need for stock price information exists to
perform the statistical tests. The databases used for this thesis have only auditor rotation
information of stock exchange quoted firms. These stock exchange quoted firms are part of the
sample of the other tests as well consequently this advantage does not apply in this thesis.
Because no broader sample can be used, the use of this model will not provide new insights.
6.2 Additional quality tests
To determine the quality of the data used to do the tests, some additional quality tests will be
performed. Tests to determine the quality are inspection for outliers, inspection for
heteroscedasticity and statistical test for multicollinearity. The way these tests will performed is
presented in this paragraph.
Outliers
To investigate and to analyze the quality and the distribution of the input, concerning each test a
scatter plot will be created. When unusual variable values are recognized will be decided if these
data need to be excluded from the sample. Because the relation between the dependent and the
independent variables is part of this thesis this investigation of the quality is necessary. When the
outliers are part of the sample no clear relation or a blurred relation could be the consequence.
Heteroscedasticity
Because the data are yearly returning data of firm results or stock prices, no reason exists to
assume that the data for the test is heteroscedastic. These stock prices and firm results are likely
to exhibit a uniform pattern as their peers and over the years.
The same method to determine outliers will be used to define the heteroscedasticity of the data.
The scatterplot is an easy method to investigate and analyze the distribution of the data. When
this data is heteroscedastic a strange shape of data points need be visible in the scatterplot.
Multicollinearity
In all tests the predictor variables consist of one scale variable and a proxy to exclude for the
development of the independent variable over the years and a dummy for the last year of the
53
auditor-client relation. When the statistical tests consist of more than one scale variable it is wise
to determine the multicollinearity of these variables with the variance inflation factor. When the
independent variables consist of one scale variable and besides only of nominal variables or
dummies it is not necessary to perform tests to determine the multicollinearity and the results of
this test are not reliable to interpret, especially in a short timeframe as the one used in this sample
(Field, 2009).
6.3 Sample selection
The sample used in this thesis consists of financial statement information of stock exchange
quoted companies located in next three countries of continental Europe the Netherlands, Belgium
and Germany. The motivation for this sample is explained in paragraph 1.3 before. All the
selected stock exchange quoted companies will be evaluated and checked if auditor rotation took
place after 2003, because from that year on financial statement information is available in the
Orbis database. This time frame is chosen to have a wide enough range to compare data before
and after the rotation and wide enough to include sufficient companies and to perform reliable
statistic tests. In addition this timeframe is used because no financial statement or stock price
data in the Orbis database are available before this date. The sample consists of all commercial
and industrial firms listed on the stock exchanges of the selected countries. Because of the
special reporting standards and the different accrual characteristics compared to industrial and
commercial firms, banks and insurance companies from the sample are excluded.
Using only countries of the European Union enables to assume that the macroeconomic setting is
the same throughout the complete sample. The political risks concerning the whole sample are
comparable and the reporting currency is for all the selected firms the euro what causes
simplicity.
Since the purpose of this thesis is to present empirical evidence about the use of conservatism
related to auditor rotation in the European Union and especially in the Netherlands, the sample
consist of the most stable European Union countries with comparable reporting and litigation
standards. For each test that will be performed in this thesis the size of the sample will be
commented and the relevant data that are used to perform the tests.
54
Accumulation of operating accruals
1,150 firm year observations are used to perform the accumulation of the operating accruals test.
Observations are from 2005 up to and included 2012. 114 observations are firms in their last year
with their current auditor. 215 observations are firm year observations before the last year with
their current auditor. 821 firm year observations are firms in years after the rotation when their
financial statements are audited by the new auditor. See table two underneath for division of the
firm year observations.
Years before final year of auditor
215
Final years of auditor
114
Years after auditor rotation
821
Total
1,150
Table 1 distribution of firm year observations acc. Of operating accruals
Just like the market to book test, a time variable is used to eliminate a time-trend in the analysis.
2004 counts 1 and it count till 9 in 2012.
The accumulation of operating accruals is calculated by deducting operating cash flow from
operating results. If this has a positive value operating accruals increase, because profit is higher
than cash flow. This difference must be reflected in the balance sheet of that specific firm year
observation.
In addition a correction is performed for the value of the total assets, to scale for company size.
This enables comparability of firm year observations of firms with different scales.
A dummy is used for the last year before the rotation. This dummy equals a value of 1 when the
relation is in its last year and zero otherwise.
55
Differential timeliness in recognizing bad and good news in the published earnings
Another kind of statistical test is used for the differential timeliness in recognizing bad news and
good news in the published earnings. This method is presented in chapter 6 considering the
research design. The total sample of 837 firm year observations from 2008 up to and included
2012 is cut in three parts: One with firm year observations of companies in the last year of the
auditor client relation, one with the other firm year observations before the last year of the
auditor-client relation and one with firm year observations after rotating the prior auditor. To test
for significance the outcomes of the variables are compared with each other. Group one with
firm year observations in the last year of the auditor-client relation are 48 firm year observation.
Group two, with firm year observations before the last year of the auditor-client relation consist
of 275 firm years. Group three, with firm year observations after the last year of the auditorclient relation consist of 514 firm years. Because of the limited availability of data in the Orbis
database, the size of the test is the most limited of the three tests. See table three underneath for
the division of firm year observations.
Years before final year of auditor
275
Final years of auditor
48
Years after auditor rotation
514
Total
837
Table 2 distribution of firm year observations diff timeliness in recognizing bad and good news in earnings
Because of the limited scale of observations of the three categories, no variable is added, to
investigate the influence of time on the use of conservatism. Earnings per share are derived from
the Orbis database for the observed years just as the stock price and the stock returns. An
interaction term is added to the test to determine the interaction effect of the negative earnings
and the size of that negative earning on the use of conservatism.
Market to book ratio test
1,080 firm year observations are used to perform this test. Observations are form 2006 up to and
included 2012. 104 observations are firms in their last year with their current auditor. 158
observations are firm year observations before the last year with their current auditor and 818
firm year observations are firms in years after the rotation when their financial statements are
56
audited by the new auditor. Table three on the next page presents the division of the firm year’s
observations.
Years before final year of auditor
158
Final years of auditor
104
Years after auditor rotation
818
Total
1,080
Table 3 distribution of firm year observations market to book
In addition a time variable is used to eliminate a time- trend in the analysis. 2006 counts 1 and it
count till 7 in 2012.
The market to book ratio is calculated by determining the market capitalization on December 31
of each firm year observation divided by the shares outstanding on that date (market
capitalization per share). This value is divided by the book value of the equity per share on that
same date. When the ratio is 1 the book value is equal to the market value. When the ratio is
higher than one, the market value is higher than the book value. And when the ratio is smaller
than one the reverse is the case.
A dummy is used for the last year before rotation. This dummy equals a value of one when the
auditor is in the last year before rotation and a zero otherwise.
6.4 Collect data
The data will be retrieved from two reliable databases, Orbis for the financial statement
information and the stock price information of the European firms for the period 2003 up to and
included 2012. In this database the next information will be retrieved. For the accumulation of
the operating accruals the operating result and the CFO figures from 2003 up to and included
2012 will be retrieved. For the differential timeliness of the published earnings, the stock price,
the earnings per share and the stock return will be retrieved. For the market-to-book ratio the
market capitalization and the net book value will be retrieved.
In addition Company.info will be used for the auditor rotation information of the selected
European Union firms concerning the same period. Concerning all stock exchange quoted
companies the engagement auditor is presented in the database from 1990 up and included 2012.
This information is used to determine in which years the auditor rotation was performed.
57
This research will be perform under the assumption that the auditor is aware of the fact that he
will be rotated after the year he is performing his final audit. Small companies can switch their
auditor without performing a tender procedure. At these small clients the chance that the auditor
is not aware of his rotation, is larger than at bigger and more complex companies. Consequently
the requirement for stock exchange quoted companies is used for selecting the sample. This
requirement in addition is necessary for the market-to-book conservatism test. All statistical tests
are performed with SPSS. This is a reliable software program which has appropriate features to
run the tests discussed before.
6.5 Attainability
Based on the research methods signaled before, it is possible to answer the research question of
this study: Does compared to prior years in the last year before rotating the auditor a higher
degree in the use of conservatism exists?
The signaled information in paragraph 6.3 necessary to perform this research can be retrieved
from the databases Company.info and Orbis. The Erasmus University has several licenses to use
these databases. In addition, the information retrieved from those databases creates sufficient
observations to perform the statistical tests signaled in this chapter.
6.6 Summary
This chapter presented the research design used for answering the research question and
examining the hypotheses. In the first paragraph the three models that will be used to determine
the use of conservatism in relation with the mandatory auditor rotation are explained. The
statistical methods are set out as well. The models are the accumulation of the operating accruals,
the difference in the timeliness of good and bad news in the publish earnings and the market-tobook ratio. The second paragraph commented the different quality checks that will be performed
on the data, to establish more confidence about the quality of data used in this thesis. In the third
paragraph the sample selection is set out. In addition in the fourth paragraph the collection of the
data is explained. In this thesis two databases will be used, Orbis concerning the financial
statement and the stock price information, and Company.info concerning the auditor rotation
information. The last paragraph of this chapter commented the attainability of the tests in this
thesis. All relevant information to perform the presented tests is available in the databases. In the
58
next chapter the outcomes of the statistical tests are presented and the last chapter will be used to
perform an analysis and derive conclusions from these statistical outcomes.
59
7. Outcomes
In this chapter only the outcomes of the statistical tests will be presented. No conclusions will be
derived from the statistical tests in this chapter, only the statistical outcomes of these tests are
presented. When a variable is significant, this fact will be signaled in this chapter, but
conclusions and recommendations will be presented in chapter 8.
7.1 Accumulation of operating accruals
Accumulation of operating accruals is the first test in determining the use of conservatism in the
financial statements. First data will be checked on quality. After some adjustments due to this
quality tests the outcome of the statistical test will be explained.
Quality check
To check the quality and the spread of the data a scatterplot is created to investigate if all input
for the tests is reliable. To perform a regression were all assumptions are met, there need to be
tested on homogeneity, normality of the observations and outliers. In addition multicollinearity
have to be eliminated.
Figure 1 P-P plot of accumulation of operating accruals
Based on figure 1 the observations differ positively and negatively from the diagonal line. When
observations are normally distributed, observations need to be near the diagonal line. To
determine if observations are normally distributed the Kolmogorov-Smirnov test is performed.
This test has a significance value of 0,000, table A Appendix 2.1. This indicates a significant
difference from a normal distribution.
60
In the P-P plot of figure 1, skewness is visible in data. Consequently the lognormal distribution
as well is tested. When the logdata is normally distributed the normal distribution assumption is
met as well and the regression could be performed.
Figure 2 Q-Q plot for log accumulation
Based on figure 2 still skewness is visible and the Kolmogorov-Smirnov statistic indicates a
significance value of 0,000, table B Appendix 2.1
Consequently, still no normal distribution in the data exists. Due to that reason a non-parametric
test has to be used, because when a parametric test is used one of the most important
assumptions, the normal distribution, is violated.
When testing the differences between two conditions and different participants have been used in
each condition, two statistical tests can be used: the Mann-Whitney test and the Wilcoxon ranksum test (Field, 2009). These tests are the non-parametric equivalents of the independent t-test
and are equivalent in their method of testing (Field, 2009). Consequently is chosen for the MannWhitney test.
Mann-Whitney test
The Mann-Whitney test assigns to every observation a rank. The lowest observed value has a
rank of 1 and the highest observed value has a rank of 1150. Consequently, the assumptions of
the parametric tests are no longer relevant. Because the highest value differs with one from the
second highest value, with this method of research outliers no longer exist.
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The Mann-Whitney statistic tests for differences between the accumulation of the operating
accruals in the last year with the auditor and the firm years observations in other years than their
last year with the auditor.
The mean rank of firms in their last year is 611 and the mean rank of firm year observations in
other years than their last is 570, table C Appendix 2.1. The difference between the two groups is
not significant, asymptotic significance of 0,207 in table D in Appendix 2.2.
Because the variables are ranked and do not have their observation value when this test is
performed, this non-parametric test is not able to determine the evolution over the years of a
variable. The Kruskal-Wallis test is only able to determine the difference between the mean in
more than three groups in a non-parametric data sample. Based on the findings of tables E and F
in Appendix 2.1 it is visible that the means between groups is significantly different. The results
indicate that there are significant differences between the different years included in this study.
Also caused by the limitations of the Kruskal-Wallis test, no interaction effects could be
determined.
As stated, the last year of the auditor has not a significant higher mean rank than the years before
and after the rotation. A higher mean rank indicates that the accumulation of the operating
accruals is higher for the firm year observations of firms in the last year with their auditor.
Because the accumulation of the operating accruals captures the level of the use of conservatism
in the earnings and not in asset or liability values, the second sub-hypothesis is relevant. In
chapter five the second alternative sub-hypothesis is formulated as follows:
Ha2
In the last year before rotating the auditor, a higher degree of the use of earnings conservatism
exists, compared to previous years.
Based on the statistical findings of this chapter, acceptance of this alternative hypothesis is not
possible. The direction of the findings, a higher rank of firms in their last year with the auditor, is
according to the direction formulated in the alternative hypothesis. This indicates more use of
conservatism in the published earnings than firm year observations of firms before and after their
last year with the auditor. However the alternative hypothesis cannot be accepted on a five
percent significance level.
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7.2 Differential timeliness in recognizing bad and good news in earnings
To perform the test on the differential timeliness in recognizing bad and good news in the
published earnings, a statistical test need to be used that could recognize a significant difference
in slope between three groups. The statistical test used is the mixed linear model of SPSS. The
data is divided in the next three groups: firm years in the years before the final year of the
auditor-client relation, firm years in the last year of the auditor client relation and firm years after
the final year of the auditor client relation. Purpose of the test is to define whether the slope of
the stock returns on the earnings per share between the three groups differs significantly. The
intercept and the other explanatory variables are marked as fixed variables and the stock return is
marked as the random explanatory variable. If a difference between groups is expected in the
slope of certain variables, these variables need to classify as random. The statistical test
determines if the fit of the model is better when this variable is classified as random. The -2 log
likelihood provides an indication for the fit of the model. The lower the value of this parameter ,
the better the fit of the model. First the mixed linear model is performed with only stock returns
as random effects. Second, the mixed linear model is performed with the intercept and the stock
returns as random effects and finally the mixed linear model is performed with only fixed effects.
This last model makes no distinction in slope of variables between the different groups. When
the fit of this last model is the best of the three tests, no significant difference exists between the
three groups.
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Information Criteriaa
-2 Log Likelihood
693.407
Akaike's Information
705.407
Criterion (AIC)
Hurvich and Tsai's Criterion
705.508
(AICC)
Bozdogan's Criterion (CAIC)
739.786
Schwarz's Bayesian Criterion
733.786
(BIC)
The information criteria are displayed in
smaller-is-better forms.
a. Dependent Variable: eps/Pt-1.
Table H fit of model with only stock returns as random effect.
First the model is performed with only stock returns as random effect, table H before in appendix
2.2. The fit of the model is 693.
Table L fit of the model with both intercept and stock returns as random effects
To determine the model with the best fit, the intercept is tried with a random effect and with only
fixed effects, see outcome in appendix 2.3 and table L respectively table O. What is visible in
table L, presented above, is that the -2 log likelihood is higher than the model presented before,
namely 703 instead of 693 (presented in table H), for a random intercept as well.
This indicates that the model with only stock returns as random effect has a better fit than the
model with intercept and stock returns as random effects.
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Table O, with only fixed variables
However, the model with only fixed effects has an even better fit of 690, see table O. What can
be derived based on the different tests is that changing the model in different groups with random
effects does not cause an increasing fit of the model. The regression outcome of the test with
only fixed effects is presented in appendix 2.3, table Q.
Much is visible based on the outcome tables of this last model with only fixed effects. Stock
returns have a significant influence on the earnings per share on a 10% significance level 0,083.
In addition the dummy variable for negative stock returns is not significant on a 10% significant
level, 0,146. The interaction term for stock return and negative stock return is significant on a
5% significance level, 0,01. The year variable is not significant, 0,66. The fact that the model
with only fixed effects has the best fit is an indication that a dataset without a split between the
three different groups has the best fit.
The differential timeliness in recognizing bad and good news in the published earnings is a test
capturing the level in the use of earnings conservatism of firms in their financial statements. This
test is one of the two tests used in this thesis to verify the significance in the use of earnings
conservatism in the last year of the auditor client relation, formulated in the second alternative
sub-hypothesis:
Ha2
In the last year before rotating the auditor, a higher degree of the use of earnings conservatism
exists, compared to previous years.
65
The model with the best fit was the one without random effects in any data. The slope of the
stock returns is not significantly different between the three groups. Based on these statistical
results could be stated that no significant difference exists between the differential timeliness in
recognizing bad and good news in the published earnings in the last year of the auditor-client
relation compared to years prior or after that year. The second alternative sub-hypothesis could
not be accepted. No significant higher level exists in the use of earnings conservatism in the last
year of the auditor client relation.
7.3 Market to book ratio
Market to book ratio is the third test in determining the use of conservatism in the financial
statements. First the data will be checked on quality. After some adjustments due to this quality
tests the outcome of the statistical test will be explained.
Quality check
To check the quality and the spread of the data, a Q-Q plot is created to investigate if the
observations have a normal distributed pattern. This is one of the assumptions to perform an
accurate regression.
Figure 3 Q-Q plot of the market to book ratio observations
In the data observations an S-shape is visible. This indicates that the data is skewed, both to the
right and to the left. In addition to test statistically if the market to book ratio has a normal
66
distribution, the Kolmogorov-Smirnov test is performed. This statistic has a significance of
0,000, table R Appendix 2.5. That indicates a significant difference from a normal distribution.
Consequently is tested for a lognormal distribution as well. When the data is log normally
distributed the normal distribution assumption is met and the regression could be performed.
Figure 4 Q-Q plot of the log (market to book ratio)
This plot seems to be skewed to the left with a few outliers on the left.
Figure 5 boxplot of log (market to book ratio)
Based on the boxplot and based on the Kolmogorov-Smirnov test the observations do not show a
normal distribution. The log values of the market to book ratio observations have many outliers.
This could indicate that the observations are not normally distributed. The Kolmogorov-Smirnov
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statistic has 0,000 significance, table S Appendix 2.5. This indicates a significant difference from
the normal distribution.
Because the most fundamental assumptions are not satisfied for the market to book ratio test, the
regression cannot be performed. Consequently conclusions derived with this test could be
inaccurate.
Mann-Whitney test
The Mann-Whitney test assigns to every observation a rank. The lowest observed value has a
rank of 1 and the highest observed value has a value of 1081. Consequently the assumptions of
the parametric tests, normal distribution and multicollinearity, are no longer relevant. Because
deviated observations differ only with a value of one from the second most deviated observation.
In addition, with this method of research no longer outliers exist.
The tables, presented in the Appendix show the differences between market to book ratio ranks
for firm years in their last year with the auditor and the firm year observations in other years than
their last year with the auditor, table T Appendix 2.5.
The mean rank of firms in the last year is 513 for firm years in their last year of the auditor client
relation and the other years have a mean rank of 543. The ranks of firm year’s observations in
the last year of the auditor client relation are lower. However these observations are not
significant, table U Appendix 2.5.
Because the variables are ranked and do not have their original values, this test is not able to
determine the evolution over the years of a variable. The Kruskal-Wallis test is only able to
determine the difference between the mean in more than three groups in a non-parametric data
sample. Based on the findings is determined that the means between groups is significantly
different, tables U and V in Appendix 2.5.
The market to book ratio test is the test formulated in chapter six to capture the level in the use of
balance sheet conservatism. This is the only test used in this thesis to verify the significance in
the use of balance sheet conservatism in the last year of the auditor client relation, formulated in
the first alternative sub-hypothesis:
68
Ha1
In the last year before rotating the auditor, a higher degree of the use of balance sheet
conservatism exists, compared to previous years.
As stated, the mean rank of firm years observations in their last year with the auditor is lower for
the market to book ratio than firm years in the years before and after this last year of the auditor.
A lower market to book ratio indicates that the book value is more in conformity with the market
values indicating smaller level of the use of balance sheet conservatism in the last year of the
auditor than observations with a higher market to book ratio. The use of balance sheet
conservatism is on average lower in this sample for firms in their last year with the auditor. This
outcome is not statistically significant; consequently, based on these findings no conclusions
could be derived. However the direction of the findings is in contrast with the prediction
formulated in the first alternative sub-hypothesis. The first alternative sub-hypothesis could not
be accepted. The direction of the findings is not in accordance with the alternative subhypothesis and the findings were not significant.
7.4 Summary and general remarks about the tests
What can be stated about the tests in general? The statistical tests capturing the influence of the
last year of the auditor are not significant. The difference in ranks between the firm years
observations divided in years is significant. All three tests approach the use of conservatism in
the financial statements in their own way. In addition the tests of differential timeliness in
recognizing good and bad news in the published earnings indicates that the model, with no
distinction between firms in their last year, before their last year and after the last year with the
auditor, has the best fit. In this test, bad news has a stronger effect on the published earnings than
good news, indicating the use of conservatism in the selected financial statements, but no
significant effect exists when the auditor is performing his last audit. In the next chapter the
statistical findings will be analyzed and conclusions will be derived.
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8. Analysis and conclusion
In this chapter the analysis of the statistical outcomes is commented and the main hypothesis is
verified. In chapter 7 the sub-hypotheses were tested and discussed. This chapter will refer to
these findings and verify the acceptability of the main hypothesis. In addition the statistical
results will be commented with existing literature. Does this thesis align with prior findings of
other research. In addition the limitations of this study are commented and the overall
conclusions and remarks will be presented.
8.1 Findings
Research and sub-hypotheses are divided in the level in the use of balance sheet conservatism
and in the level in the use of earnings conservatism. Two tests are performed to test the use of
earnings conservatism, accumulation of the operating accruals and the differential timeliness.
Both tests did not show a significant higher level in the use of earnings conservatism, but the
direction of the findings indicate a higher level of earnings conservatism in the last year of the
auditor client relation. In addition the market to book ratio test is used to capture the use in
balance sheet conservatism. In the last year of the auditor-client relation no significant higher
level of balance sheet conservatism was visible compared to prior years or years of the last year.
Contrastingly, there was a different direction visible of the data, compared to the hypothesis.
Summarized, could be stated that no significant higher level exist in the use of conservatism in
the last year of the auditor-client relation. The hypothesis ‘In the last year before rotating the
auditor, a higher degree of the use of conservatism exists, compared to previous years.’could not
be accepted based on the statistical findings in this thesis. The change in dynamics in the last
year of the auditor client relation has no such influence on the reported figures in the annual
financial statements that the use of conservatism is present in a significantly higher fashion than
in other years.
70
8.2 Comparison with prior research
The overall conclusion is that no higher level exists in earnings and balance sheet conservatism
in the last year of the auditor client relation in Germany, in Belgium and in the Netherlands.
Over the years the time trend in the balance sheet and in the earnings conservatism is significant.
Earnings conservatism is increasing in time, independent of the audit tenure (mixed linear
model). Balance sheet conservatism has a difference in mean rank over the years as well (MannWhitney test). The average rank over the years of balance sheet conservatism decreases,
indicating a lower level of balance sheet conservatism. This is in conformity with authors that
perform research on the interaction between the two conservatisms, like Garcia Lara & Mora
(2004). They stated that use of one of the two conservatisms limits the necessity to use the other
conservatism. When one of the two is high the other conservatism is low and vice versa. This
thesis had no interaction between the balance sheet and the earnings conservatism in its scope,
but this contrasting time trends could be explained with the article by Garcia Lara & Mora
(2004).
The tendency towards more conservatism in earnings and less conservatism in the balance sheet
could be explained from the implementation of IFRS. The valuation of balance items in Europe
is more and more fair value. Joos & Lang (1994) researched in their study the influence of
regulation and financial structure on the use of conservatism in the financial statements. When
reporting standards are strict , there is not much space to use conservatism in the balance sheet.
Especially when the reporting standards tend to less conservatism in the balance sheet, less
conservatism could be expected. The effect in earnings is vice versa. There is a natural force in
reported figures to use conservatism no matter what the regulation prescribe. Litigation risk is
still strong enough to maintain conservatism.
In addition Germany is more than half of the observations used in this thesis part of the data.
They have a long history of conservative reporting, because their standards before IFRS were
based on tax regulation. Garcia, Lara & Mora (2004) found in their study the highest use of
balance sheet conservatism in Germany. The sample of this thesis is starting after
implementation of IFRS. That reporting is become less conservative over time could be caused
by Germany that came from a very high level of conservatism.
71
Myers et al. (2003) state that there are less accruals when the tenure of the auditor increases.
Johnson et al. (2002) state that short tenures and at the beginning of the auditor client relation
accruals are higher. These two studies found that the longer the relation between the auditor and
the client, the use of accruals diminishes. In this thesis we found a higher level of accumulation
of accruals in the last year of the relation. The scope of these studies is on the tenure of the
auditor client relation. The scope of this thesis is different than the scope of the two other
studies, namely on the last year. There is no research done on the duration of the relation
between the auditor and the client. Comparison of the results with their results is not possible to
do.
Kramer et al. (2011) found evidence that a higher level in the use of earnings conservatism exists
in the year after rotation. The year before rotation was not in their scope of study. The study of
Kramer et al. (2011) is performed in North America. There is a higher litigation risk in northern
America than in continental Europe. When rotation takes place and the auditor is not familiar
with all aspects of the client in his first year, he would rather accept more conservative values
than non-conservative values. All this to mitigate litigation risk. In Europe this litigation risk is
less severe than in northern America. For this reason findings of Kramer et al. (2011) might
differ from the findings of this thesis. Because the scopes of this thesis and the study of Kramer
et al. (2011) differ and did not investigate the same phenomenon comparison with this study
must be done with great caution.
The initial reason to perform this thesis was to investigate if the information value of the annual
financial statements is lower when the auditor rotation becomes mandatory. Expectation of this
thesis was that the use of conservatism was higher in the last year and the information value and
the comparability with other firms and between years is lower due to this mandatory rotation.
Based on the results in this thesis study could not be stated that information usefulness decreases
when the auditor rotates. The experimental findings of Wang & Tuttle (2009) that in the last year
non-cooperative behavior of the auditor causes lower balance sheet values in this thesis has not
been detected. The direction of these findings is in contrast with their findings, however not
significantly. The reason for this deviation from their findings is the method of research. The
experimental setting they created is too restricted to derive conclusions with enough external
validity for the real world. In an experiment other dynamics are present in the market place that
enforces auditors to follow non-conservative assertions of management in the last year of the
72
relation. Another reason for deviations with their research is the internal validity of their
research. In their experiment they could capture the influence of mandatory auditor rotation and
their findings are not blurred with omitted variables not counted for. In an archival study, like
this thesis, the internal validity is lower and the use of conservatism could be caused due to other
reasons than the ones investigated.
Proponents and opponents hope for respectively fear for decreasing audit quality due to rotation
of the auditor (Raiborn, Schorg & Massoud, 2006). Audit quality is not investigated in this
thesis, but information usefulness, captured with the level of the use of conservatism of the
annual financial statements is not significantly harmed with auditor rotation. The arguments of
proponents and opponents of mandatory auditor rotation presented in the study of Raiborn,
Schorg & Massoud (2006), are partly not based on empirical findings.
8.3 Conclusions
To summarize the findings of this thesis in relation with prior research, the following could be
stated. There is no significant evidence to support the hypothesis formulated in this thesis. There
is no higher level of conservatism in the last year of the auditor-client relation compared to years
prior and after the rotation. The direction of earnings conservatism is in line with the hypothesis:
There is more earnings conservatism in the reported annual statements in the last year of the
auditor client relation. However this conservatism is not significant. In the use of balance sheet
conservatism in opposing trend is visible.
A lower use in balance sheet conservatism could be explained by the implementation of IFRS.
These international reporting standards tend towards the use of fair value reporting of balance
sheet values. The opposing interaction between balance sheet conservatism and earnings
conservatism is in line with prior studies of Garcia, Lara & Mora (2004) and Joos & Lang
(1994).
A higher level of conservatism in the last year of the auditor client relation is not in line with the
findings of Wang & Tuttle (2009). Their experimental research showed a higher level of
conservatism in balance sheet values in the last year of the auditor-client relation. In this thesis
the last year of the auditor client relation shows another direction in balance sheet conservatism
than the one found by Wang & Tuttle (2009). Less balance sheet conservatism instead of more.
73
In addition, from an information usefulness point of view, restricted to the use of conservatism in
the annual financial statements, auditor rotation is not blameworthy. The use of conservatism,
both earnings and balance sheet conservatism is not statistically significant. Rotation of the
auditor has no significant influence on the information usefulness of the annual financial
statements.
8.4 Limitations
A major limitation of this thesis is the assumption that the auditor knows, before doing his last
audit at the client, he will be rotated. This assumption is used because this thesis wants to add
input for the communication about the mandatory auditor rotation and tried to derive conclusions
about the mandatory auditor rotation. When auditor rotation is mandatory, the auditor is aware
when he is performing his last audit for the client of the upcoming rotation. In the three selected
European countries rotation is not yet mandatory. To create a sample were this knowledge of
rotation is to a large extent present before starting the audit; large stock exchanges quoted
companies have been selected. The rotation of the auditor at this kind of firms is introduced on
average with a tender procedure. This is a formal procedure which often takes months before the
new auditor is selected. With this procedure the current auditor is aware before doing the final
audit that it will be his last year of the engagement. If the use of conservatism is observed this
can possibly be ascribed to this knowledge of rotation and not to coincidence. Due to the reason
that rotation is not yet mandatory, drawing conclusions is performed with great caution, about on
which way mandatory auditor rotation adds to the use of conservatism.
Another limitation is the reason for the rotation. Since rotation is voluntary, a dispute between
the auditor and the client, financial distress of the audited firm or auditor litigation could be the
reason for the rotation. These reasons could all have a consequence for the reported figures of the
audited firm. To mitigate continuity issues of the firms, firm years that are not present in the
whole time-frame are excluded. Maybe, still correlated omitted variables exist that in the models
are not implemented as a control variable.
In addition the countries used in this thesis are not identical or highly comparable with other
countries in the western world. Country specific characteristics, like litigation and culture, limit
the possibility of the generalization of the findings.
Another limitation is the limited timeframe of the firm years included in the statistical test.
Because the Orbis database had no information about the financial statements and the stock
74
prices before that year, only firm years after 2003 are part of this thesis. This limitation causes a
limited quantity of the auditor rotations in the countries under study and besides that it is hard to
determine a development in the use of conservatism over the years.
8.5 Recommendations for further research
As stated in the prior paragraph, the sample was small due to the limitations in the database and
the selected countries. This limitation made it hard to derive statistically significant conclusions.
In later research the sample of countries could be extended with comparable countries in the
European Union. In addition performing this study again in ten years creates a broader and more
divers sample of firms were rotation took place. Optimally to derive the best conclusions it is
best waiting with this research till the years that mandatory auditor rotation is implemented and
the consequences in practices are visible. Waiting till this moment eliminates omitted variables
in the study which could not be excluded based on a sample were only voluntary rotation took
place.
In addition there is a tendency visible towards less balance sheet conservatism. To determine the
influence of IFRS and the influence of other factors, a larger timeframe or comparison between
countries with and without IFRS should be performed. This is especially interesting, because an
interaction effect between the use of earnings conservatism and balance sheet conservatism
appears to be present.
Besides the recommendation stated before, another recommendation is to focus on other aspects
than conservatism in the annual financial reports, like audit quality. Conservatism does indicate
something about audit quality, Kramer et al., 2011, but this research could be extended with
other models to derive conclusions about mandatory auditor rotation on audit quality in the
European Union.
75
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Appendices
Appendix 1 Literature review
(1)Author and
name of the article
(2)object of
study
(3)sample
(4)research methodology
(5)outcome
Joos &
Lang(1994).The
effects of
accounting diversity
from the European
Union
Balance sheet
conservatism
in different
European
countries:
Germany,
France and the
UK.
8000 firm year
observations in
the three
countries
equally spread
over the years
from 1982 till
1990.
univariate analysis, price
regressions and return
regressions
Balance sheet conservatism was
significantly greater in Germany
than in the UK and France. And
balance sheet conservatism in
the continental countries
(Germany and France), was
significantly greater than
balance sheet conservatism in
the UK
Basu (1997). The
conservatism
principle and the
asymmetric
timeliness in
earnings
Earnings
conservatism:
asymmetric
timeliness in
earnings.
Faster
recognition of
bad news in
earnings than
good news.
US firm
observations
from the CRSP
database with
observations
from 1963 till
1990 and the
corresponding
accounting files
from Compustat
reverse regression
EPSit/Pi,t-1 = α0 + α1DRit
+ β0Rit + β1DRit*Rit + εit
The outcome of the study is that
there is asymmetric timeliness
in earnings. Bad news has
stronger influence on earnings
and the predictive power of bad
news on earnings is larger than
the predictive power of good
news on earnings. In addition he
found that accruals are used to
report conservative. In addition
evidence is found that negative
earnings are frequently
reverting to positive earnings in
next period, due to
conservatism.
80
Where
EPSit = earnings per share
of firm i in fiscal year t;
Pi,t-1 = price per share at
the beginning of the fiscal
year;
Rit = return of firm i over
the twelve months
beginning nine months
prior to the
end of fiscal year t;
DRit = dummy variable set
equal to 1 if Rit is negative
and 0 otherwise
(1)Author and
name of the article
(2)object of
study
(3)sample
(4)research methodology
(5)outcome
S. T. Kramer & G.
Georgakopoulos,
‘Audit firm rotation,
Audit firm tenure
and earnings
conservatism
(International
Journal of Business
and Management),
vol 6 (8) 2011 p.4457.
The authors
attempt to
address here
the relation
between auditfirm rotation,
audit firm
tenure and
conservatism
as an attribute
of earnings
quality.
The sample
consists of firm
year
observation for
the years 1980
till 2006 from
the Compustat
North America
Industrial
Annual
database. A
total of 11,643
firm years are
used in the
sample.
The researchers performed
a regression analysis with
earnings as the dependent
variable. Independent
variables are the stock
returns, a dummy variable
with a value of 1 when
returns are lower than zero
and zero otherwise.
The influence of bad news on
earnings is much larger than the
influence of good news. When
the regression is performed in
the sample consisting of firms
in their first year after audit firm
rotation the regression shows a
higher R-squared. This provides
some initial evidence that audit
firm rotation is associated with
higher levels of conservatism in
reported earnings. In addition
levels of conservatism in
reported earnings are higher for
short audit firm tenure than they
are for long audit firm tenure.
This is inconsistent with prior
research.
V.E. Johnson, I.K.
Khurana & J.K.
Reynolds, “Auditfirm tenure and the
quality of financial
reports,
Contemporary
Accounting
Research Vol. 19
(2002), p. 637-660.
Is the length of
the
relationship
between a
company and
an audit firm
(audit-firm
tenure)
associated
with financialreporting
quality?
The authors
used the
Compustat files
of firms that do
not change their
fiscal years in
the years 19861995. 11,148
observations are
left in the
sample.
Two proxies are used for
the financial-reporting
quality: The absolute value
of the unexpected, the
persistence of accruals into
earnings in the subsequent
years. The audit firm tenure
is divided in short tenure
(2-3 years), medium, (4-8
years) or long (>8 years). A
regression analysis is
performed.
Accruals are significantly less
persistent with next period’s
earnings in the short tenure
sample, compared to the
medium sample. The research
suggests that in a nonmandatory rotation legislation
setting, there is no association
between long audit tenure and a
decline in quality of financial
reports. An association exists
between a short tenure and more
unexpected accruals and less
persistence of accruals on next
period’s earnings. Indicating
that in the starting years of the
relation there is lower quality in
financial reports.
81
(1)Author and
name of the article
(2)object of
study
(3)sample
(4)research methodology
(5)outcome
A.B. Jackson, M.
Moldrich & P.
Roebuck,
‘Mandatory audit
firm rotation and
audit quality’,
Managerial
Auditing Journal,
Vol. 23 (5) 2008, p.
420-437.
The relation
between audit
firm tenure
and audit
quality. In
addition the
aim of this
study is to
understand
whether the
client’s
financial
characteristics
under the
predecessor
auditor have
an impact on
the audit
quality under
the incumbent
auditor.
The sample of
this study
consists of
auditor switches
between 1995
and 2003 for
Australian
listed entities.
The total
observations in
the data are 772
auditor
switches. Of
these
observations,
205 were
complete for all
variables.
The authors use a logistic
regression and descriptive
statistics to investigate if
audit-client tenure increases
the likelihood of the auditor
issuing a going concern
audit opinion. To
investigate if audit tenure is
associated with
discretionary accruals, the
authors used a multivariate
regression.
The results show a positive
relation between the auditorclient tenure and the propensity
to issue a going concern
opinion. The relation between
auditor tenure and discretionary
accruals as a proxy for audit
quality is not significant. The
results suggest that the length of
audit tenure does not have a
statistical significant effect on
audit quality, as measured by
the level discretionary accruals,
and the propensity to issue a
going concern audit opinion
increases with the length of
audit firm tenure. Mandatory
auditor rotation would not be
beneficial to the market, due to
the high costs and the absence
of any benefits.
N. Dopuch, R.R.
King & R.
Schwartz, ‘ An
Experimental
investigation of
retention and
rotation
requirements’, vol
39(1), p. 93-117.
Purpose of the
study is to
provide results
from an
experiment
designed to
investigate
how
mandatory
rotation and/or
retention of
auditors may
increase
auditors’
independence.
The authors had
three sessions
in all the four
settings with 12
subjects. A total
of 144 subjects
participated in
the experiment.
The participants
were told that
the experiment
last 25 periods.
So there was no
known endpoint
what could
influence their
strategies
The study consists out of a
multi-period interaction
between a manager who
invest in a risky asset and
an auditor who gives his
opinion about this asset. A
regression is used to
determine the influence of a
setting to an outcome.
Auditors are more willing to
issue a favorable report to the
managers when dismissal of the
auditor is allowed. In the two
settings where dismissal is not
allowed, for the three years,
auditors issue more frequently a
low report when investments are
low than when dismissal is
allowed. Auditors in a
mandatory rotation and
retention setting are less
compromised in their
independence than the other
settings. They issue less
frequent an H report when a low
investment is done. In addition
in the final year before rotation
auditors are less willing to issue
a high report. The outcomes
indicate that mandatory rotation
and retention could increase the
independence of the auditor
82
(1)Author and
name of the article
(2)object of
study
(3)sample
(4)research methodology
(5)outcome
J.N. Myers, L. A.
Myers and T.C.
Omer, ‘Exploring
the term of the
auditor-client
relationship and the
quality of earnings:
A case for
mandatory auditor
rotation?’, vol. 78,
pp. 779-799.
The object of
study is the
effect of
auditor tenure
on audit
quality. The
authors
examine the
argument for
mandatory
auditor
rotation that
longer auditor
tenure leads to
a lower audit
quality.
The Authors used
univariate analyses of
auditor tenure on accruals
(proxy for audit quality)
and a multivariate
regression of auditor tenure
on accruals while
controlling for several other
factors.
The results of the study show
that the accrual measures show
less dispersion with increased
auditor tenure and that auditors
place greater constraints on
income increasing and income
decreasing accruals with longer
auditor tenure. These results
suggest that audit quality does
not decrease with longer auditor
tenure.
C.L. Comunale and
T.R. Sexton,
‘Mandatory auditor
rotation and
retention: impact on
market share’, Vol.
20, pp. 235-248.
This study
examines the
effects of
mandatory
auditor
rotation and
mandatory
auditor
retention on
the audit
marker shares
for the Big 5
audit firms.
The sample
consists of all
firm-years from
1988 to 2000 in
the Compustat
annual
industrial and
research files.
Only firm-years
of firms with at
least six years
of prior data
and a auditorclient
relationship of
at least 5 years
are included
leading to
42.302 firmyear
observations.
The sample of
this study
consists of data
from companies
listed in the
S&P 500 in the
period 19951999 which are
audited by a
Big 5 audit
firm.
Market share of an audit
firm is calculated by
dividing the number of S&P
500 firms audited by one of
the Big 5 firm by the total
number of S&P 500 firms
audited by Big 5 audit
firms. The authors use a
(expanded) Markov model
to depict the movements of
client firms among the Big
5 auditors.
The results show that mandatory
auditor rotation will have an
effect on the market shares of
the different Big 5 audit firms
and that this effect is almost the
same, regardless of the length of
the rotation period. For
mandatory auditor retention the
results show close to none effect
on the market shares. Further
the authors find that in a
mandatory rotation setting the
market share depends more on
the ability to attract new clients,
than on the ability to retain
existing clients.
83
Appendix 2 (additional statistical outcomes)
2.1 SPSS outcomes Accumulation of operating Accruals
Table A: A significant statistic. This indicates that a significant difference exists from a normal
distribution in the data in the accumulation of the operating accruals.
Tests of Normality
Kolmogorov-Smirnova
Statistic
positief
.049
df
1150
Shapiro-Wilk
Sig.
.000
Statistic
.971
Df
1150
Sig.
.000
a. Lilliefors Significance Correction
Table B: A significant statistic. This indicates that a significant difference exists from a normal
distribution in the data of log (accumulation of the operating accruals)
Table C: Mean rank of firm years in their last year with the auditor is 611, other years has a
mean value of 570.
84
Table D: Man-Whitney test with the statistical differences between the ranks of firms in their last
year with the auditor and firms in years before and after the last year. Not significant
Table E: Mean rank of different years in the accumulation of the operating accruals.
85
Table F: Significance in difference between the mean ranks of groups of years.
2.2 SPSS outcomes Asymmetry in recognizing good and bad news in earnings
SPSS outcomes with only stock returns as random effects
Model Dimensionb
Fixed Effects
Random Effects
Number of
Covariance
Number of
Subject
Levels
Structure
Parameters
Variables
Intercept
1
1
Interactie
1
1
VAR00002
1
1
Yearvar
1
1
Stockreturnsa
1
Variance
1
Components
Residual
Total
1
5
6
b. Dependent Variable: eps/Pt-1.
Table G: The description of the model.
86
group1
Information Criteriaa
-2 Log Likelihood
693.407
Akaike's Information
705.407
Criterion (AIC)
Hurvich and Tsai's Criterion
705.508
(AICC)
Bozdogan's Criterion
739.786
(CAIC)
Schwarz's Bayesian
733.786
Criterion (BIC)
The information criteria are displayed in
smaller-is-better forms.
a. Dependent Variable: eps/Pt-1.
Table H: The fit of the model. The lower value -2 log likelihood has the better the fit of the model.
Table I: The estimate of the fixed effects in of the model.
Table J: The estimate of the random effects of the model. No significance of the stock returns.
87
2.3 SPSS outcomes Asymmetry in recognizing good and bad news in earnings
SPSS outcomes with the random effects of intercept and stock returns.
Table K: The description of the model.
Table L: The fit of the model. The lower value -2 log likelihood has the better the fit of the model
Table M: The estimate of the fixed effects in of the model.
88
Table N: The estimate of the random effects of the model. No significance of the stock returns.
89
2.4 SPSS outcomes Asymmetry in recognizing good and bad news in earnings
SPSS outcomes with only fixed effects
Table O: The description of the model.
Table P: The fit of the model. The lower value -2 log likelihood has the better the fit of the model.
Table Q: The estimate of the fixed effects in of the model.
90
2.5 SPSS outcomes Market to book ratio test
Tests of Normality
Kolmogorov-Smirnova
Statistic
m2b
.237
df
1081
Shapiro-Wilk
Sig.
.000
Statistic
.561
df
1081
Sig.
.000
a. Lilliefors Significance Correction
Table R: A significant statistic. This indicates that a significant difference exists from a normal
distribution in the data market to book ratio.
Table S: A significant statistic. This indicates that a significant difference exists from a normal
distribution in the data of log (accumulation of operating accruals)
Table T: Mean ranks of Market to book ratio of firms in their last year with the auditor and years
prior and after that last year.
Table U: Man-Whitney test of significance in difference between ranks
91
Table V: Mean rank of the market to book ratio in the different years.
Table W: Significance in difference between the mean ranks of groups of years.
92