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Journal of Accounting and Public Policy 26 (2007) 131–159 www.elsevier.com/locate/jaccpubpol Audit firm tenure and
Journal of Accounting and Public Policy 26 (2007) 131–159 www.elsevier.com/locate/jaccpubpol Audit firm tenure and
Journal of Accounting and Public Policy 26 (2007) 131–159 www.elsevier.com/locate/jaccpubpol Audit firm tenure and

Journal of Accounting and Public Policy 26 (2007) 131–159 www.elsevier.com/locate/jaccpubpol

Audit firm tenure and financial restatements: An analysis of industry specialization and fee effects

Jonathan D. Stanley a,1 , F. Todd DeZoort b, *

a The University of Alabama, Culverhouse School of Accountancy, 365 Alston Hall, Tuscaloosa, AL 35487-0220, United States

b The University of Alabama, Culverhouse School of Accountancy, 328 Alston Hall, Tuscaloosa, AL 35487-0220, United States

Abstract

This study investigates the relation between audit firm tenure and clients’ financial restatements. Specifically, we extend the audit tenure literature by assessing restate- ment-based reporting failures using dimensions of auditor expertise and independence previously assumed to underlie short and long audit tenure problems. Short tenure expertise and independence effects are hypothesized using audit firm industry specializa- tion and audit fees as proxies. Long tenure independence effects are hypothesized using nonaudit fees as a proxy. Using matched-sample logistic regression and 382 companies with and without financial restatements during 2000–2004, the results support prior findings by indicating a negative relation between the length of the auditor–client rela- tionship and the likelihood of restatement. For short tenure engagements, we find that auditor industry specialization and audit fees are negatively related to the likelihood of restatement. This result is consistent with concerns about reduced audit quality due to a lack of client-specific knowledge and low audit fees on new audit engagements.

* Corresponding author. Tel.: +1 205 348 6694; fax: +1 205 348 8453. E-mail addresses: jstanley@cba.ua.edu (J.D. Stanley), tdezoort@cba.ua.edu (F. Todd DeZoort). 1 Tel.: +1 205 348 6131.

0278-4254/$ - see front matter 2007 Elsevier Inc. All rights reserved.

doi:10.1016/j.jaccpubpol.2007.02.003

132 J.D. Stanley, F. Todd DeZoort / Journal of Accounting and Public Policy 26 (2007) 131–159

Alternatively, the long tenure results indicate an insignificant relation between nonaudit fees and the likelihood of restatement. This finding contradicts independence concerns about nonaudit fees paid to entrenched auditors. 2007 Elsevier Inc. All rights reserved.

Keywords: Audit tenure; Financial restatements; Industry specialization; Audit fees; Nonaudit fees

1. Introduction

The objective of this study is to investigate the relation between audit firm tenure and financial restatements. We extend the audit tenure literature by examining short tenure and long tenure expertise and independence factors previously only assumed to underlie the tenure problem. For example, Johnson et al. (2002) found that short audit tenures were inversely related to clients’ abnormal accruals, suggesting that a lack of client-specific knowledge or pres- sure to retain and profit from new clients could undermine audit quality. Gei- ger and Raghunandan (2002) made similar suggestions when interpreting their findings of an inverse relation between audit tenure and the likelihood of a bankrupt company previously receiving an unqualified audit report. While both studies draw attention to longstanding concern about short tenure effects, there is little direct empirical evidence to support or refute suggestions that the effects are a function of auditor expertise and/or independence. Beyond short tenure concerns, interest in long tenure problems continues despite a lack of empirical evidence indicating their existence. The GAO (2003) highlighted that pressure to retain longstanding clients and high comfort levels with client management support calls for mandatory audit firm change to maintain adequate auditor objectivity and professional skepticism. 2 The Chair- man and CEO of TIAA-CREF ( Biggs, 2002 ) argued before the US Senate for mandatory audit firm rotation every five to seven years to (1) reduce auditors’ financial incentives to subordinate judgment to management, (2) reduce the problem of cross-selling consulting and other services, and (3) close the ‘‘revol- ving door’’ that allows auditors to move to audit-sensitive positions in audited companies. Despite counterarguments emphasizing the importance of continu- ity and expertise in maintaining audit quality, the Sarbanes-Oxley Act (2002) mandated further study of the audit firm rotation issues. 3 This study revisits

2 The GAO (2003) recommended that a decision about mandatory audit firm rotation be deferred to allow time to evaluate the effectiveness of the Sarbanes-Oxley Act’s provisions. However, it also recommended that audit committees consider rotating audit firms when there is ‘‘lengthy tenure of the auditor of record’’ (p. 51).

3 The Sarbanes-Oxley Act (2002) highlights the difference between audit partner rotation and audit firm rotation. Specifically, while the Act only requires further study of the audit firm rotation issue, it mandates lead and concurring partner rotation every five years.

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the long tenure independence question using nonaudit fees as a proxy for audit firm independence. We consider financial restatements to be a unique and substantive domain for studying the relationship between audit tenure and financial reporting qual- ity for two reasons. First, financial restatements due to error or fraud are de facto reporting failures. 4 When audited financial statements are restated, the validity of the audit opinion and the underlying audit process are subject to question because the originally released information was not free from material misstatement. While the extant literature (e.g., Geiger and Raghunandan, 2002; Johnson et al., 2002; Chung and Kallapur, 2003; Myers et al., 2003 ) pro- vides some evidence of tenure effects using alternative quality proxies (e.g., abnormal accruals, audit opinions), our use of restatements helps address Car- cello and Nagy’s (2004b) call for tenure effects research using objective and direct measures of financial reporting quality. Second, financial restatements among public companies represent a costly problem in US capital markets. The GAO (2002) estimated that restate- ments involving accounting irregularities increased 145% and cost investors approximately $100 billion during the five-year period ending June 30, 2002. The SEC (2002) listed financial restatements as a major factor undermining investor confidence in financial reporting and market efficiency. In addition, numerous empirical studies (e.g., Dechow et al., 1996; Turner et al., 2001; Wu, 2003; Palmrose et al., 2004 ) provide evidence of strong negative mar- ket reactions to restatement announcements. Consideration of factors underlying restatement-based reporting failures has brought the external audit function under severe scrutiny ( AICPA, 2002; GAO, 2002 ). One spe- cific external audit attribute that has long been associated with auditors’ ability to provide adequate assurance is the length of the auditor–client relationship (e.g., Mautz and Sharaf, 1961; AICPA, 1978; POB, 2000; Imh- off, 2003 ). Using matched samples of restatement and non-restatement companies, the results indicate a significant inverse relation between audit tenure and the like- lihood of financial restatement. For companies with short audit tenures, the multivariate results indicate that industry specialization and audit fees are inversely related to the likelihood of restatement. Finally, we find no evidence that nonaudit fees for long audit tenure companies are positively related to the likelihood of restatement. Collectively, these results contribute to the tenure effects literature by providing evidence that audit tenure problems documented in other reporting domains (e.g., accrual accounting, going concern opinions)

4 Not all restatements are a result of errors or fraud in previously reported financial statements. For example, certain changes in accounting principle require restatement of prior period financial statements. These mandated restatements are beyond the scope of this study because they are not reporting failures.

134 J.D. Stanley, F. Todd DeZoort / Journal of Accounting and Public Policy 26 (2007) 131–159

are robust to financial reporting failures reported in formal restatements. These results also extend the literature by empirically addressing expertise and inde- pendence factors previously only speculated as relevant to tenure-related finan- cial reporting problems. The remainder of this paper is organized into four parts. Section 2 provides the hypothesis development. Section 3 describes the study’s design and method. Section 4 presents the results. The final section concludes with discussion of the study’s implications and limitations.

2. Literature and hypothesis development

2.1. Audit tenure effects

Previous audit tenure studies (e.g., Geiger and Raghunandan, 2002; John- son et al., 2002; Myers et al., 2003; Mansi et al., 2004; Carcello and Nagy, 2004b; Ghosh and Moon, 2005 ) have predicted early tenure audit and financial reporting problems due to a lack of client-specific knowledge and/or a lack of independence due to the auditor’s incentive to maintain new client relation- ships. Studies in this area have used a single audit tenure variable (length of auditor–client relationship) to evaluate links between audit tenure and various proxies for audit/financial reporting quality. For example, several studies provide evidence of a link between the length of the auditor–client relationship and accrual quality. Johnson et al. (2002) found that audit tenure of less than three years was associated with higher absolute levels of unexpected accruals and lower accrual persistence in earn- ings. Similarly, Chung and Kallapur (2003) found that the length of the auditor–client relationship was inversely related to abnormal accruals. Myers et al. (2003) found a positive relation between the length of auditor–client relationship and earnings quality (proxied by discretionary and current accruals). The tenure effects literature also extends to audit reporting and regula- tion. Geiger and Raghunandan (2002) used knowledge and independence arguments when questioning whether the length of auditor–client relation- ship was related to the issuance of going concern opinions for bankrupt companies. Their results indicated that the likelihood of a company receiv- ing a going concern opinion prior to bankruptcy was lower when auditors were in the initial years of the engagement. Carcello and Nagy (2004b) eval- uated audit tenure affects among companies with fraudulent financial report- ing identified in SEC Accounting and Auditing Enforcement Releases (AAERs). They find that the likelihood of fraudulent financial reporting is greater in the initial three years of audit tenure. Alternatively, they do

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not find that long audit tenure is associated with increased likelihood of fraud. Other recent studies extend the literature by considering market-based audit tenure effects. Overall, results in this area suggest that market partici- pants discount the auditor’s monitoring ability during initial audit engage- ment years, consistent with a perception that audit/financial reporting quality increases with tenure. For example, Mansi et al. (2004) document an inverse relation between firms’ cost of public debt and auditor tenure. Similarly, Ghosh and Moon (2005) show that the impact of reported earnings on (1) stock returns, (2) stock rankings, and (3) analysts’ one-year-ahead earnings forecasts is directly related to the length of the auditor–client relationship. We extend the literature involving the length of the auditor–client relation- ship to examine whether previous findings are robust in the context of financial restatements. Specifically, prior to specific assessment of potential factors underlying audit tenure effects, we predict an overall inverse relation between audit tenure and client financial restatement. Stated formally:

H1: The likelihood of financial restatement is inversely related to the length of the auditor–client relationship.

2.2. Audit firm expertise

While prior studies discuss audit expertise and independence as potential underlying causes of audit tenure effects, empirical evidence is lacking. We test the effects of audit firm industry specialization as a dimension of expertise that can facilitate audit effectiveness in new engagements. Both Ashton (1991) and Bonner and Lewis (1990) found that industry expertise was positively correlated with an auditor’s ability to identify problems within financial statements. Auditors gain industry expertise by working with clients from within an industry and by becoming familiar with the industry’s unique accounting practices and risks. Industry expertise is related to auditor tenure because industry expertise can help compensate for a lack of client-specific knowledge. More specifically, to the extent that a new audit client operates in an industry where the audit firm has exten- sive experience and knowledge, the engagement learning curve should be less pronounced. Theories explaining the effect of industry expertise on auditor judgment and decision-making (JDM) remain largely untested at the audit firm level ( Gram- ling and Stone, 2001 ). However, several studies (e.g., Carcello and Nagy, 2004a; Krishnan, 2003 ) posit that increases in industry expertise at the audit firm level should be related to increases in industry expertise at the individ- ual auditor level. Industry specialist firms are likely to have developed

136 J.D. Stanley, F. Todd DeZoort / Journal of Accounting and Public Policy 26 (2007) 131–159

industry-specific training materials, databases, checklists, and other audit sup- port aids (Carcello and Nagy, 2004a; Krishnan, 2003 ). The empirical literature is starting to provide evidence of a positive link between industry specialization at the audit firm level and financial reporting quality. For example, Dunn and Mayhew (2004) found a positive associa- tion between audit firm industry specialization and client disclosure quality proxied by analysts’ evaluations in AIMR reports. Carcello and Nagy (2004a) found a negative association between audit firm industry specializa- tion and client financial fraud disclosed in SEC AAERs. Furthermore, the extant literature provides evidence that clients of industry specialist audit firms have larger earnings response coefficients (e.g., Balsam et al., 2003 ) and lower levels of discretionary accruals (e.g., Balsam et al., 2003; Krish- nan, 2003 ). These studies’ results support the prediction of a significant rela- tion between industry specialization and the likelihood of financial restatement. Specifically, audit firms that enter new audit engagements with relatively high industry specialization should be able to provide higher audit quality that lessens the chance of financial restatements. Stated formally (in alternative form):

H2: For companies with short audit tenures, the likelihood of financial restatement is inversely related to the audit firm’s industry specialization.

2.3. Audit firm independence

Accounting policymakers (e.g., GAO, 2003; SEC, 2000, 2003 ) have argued that auditor independence is affected by audit tenure. Consistent with this concern, a number of studies (e.g., Simon and Francis, 1988; Ettr- edge and Greenberg, 1990; Deis and Giroux, 1996; Sankaraguruswamy and Whisenant, 2005 ) have found that auditors frequently engage in low balling tactics where they offer audit services at prices substantially below market value or cost to attract new clients. Theoretically, future quasi-rents earned by incumbent auditors justify and offset losses on the early engagements (DeAngelo, 1981 ). Despite a lack of supportive evidence ( Watkins et al., 2004 ), regulators have been critical of this practice because of the perceived independence problems it creates. For example, the Commission on Auditors’ Responsibilities (1978) issued a report (the Cohen Report ) arguing that performing audit services below cost with the intention of recouping upfront losses at a later date is similar to per- forming audit services for a client that has unpaid audit fees outstanding (AICPA, 1978 ). This regulatory concern is supported by findings from studies examining the psychology of sunk costs. Simon and Francis (1988) suggest that sunk costs resulting from lowball audit fees create an escalated commitment to

J.D. Stanley, F. Todd DeZoort / Journal of Accounting and Public Policy 26 (2007) 131–159 137

continue the engagement in an attempt to recover the initial loss in later years. 5 This commitment hinders auditor independence above and beyond the economic bond resulting from future quasi-rents. The empirical literature provides evidence of tenure effects in the initial years of auditor–client relationships. For example, adverse tenure effects documented by Geiger and Raghunandan (2002), and Johnson et al. (2002) lessened when auditor–client relationships exceeded five years and three years, respectively. These findings would be expected if such adverse short tenure effects were a function of lowball audit fees that reverted to normal levels after the initial audit years ( Simon and Francis, 1988 ). Accordingly, we hypothesize an associ- ation between audit fees and the likelihood of financial restatement by a com- pany with a short audit firm tenure. Specifically, relatively low audit fees should be positively related to the likelihood of restatement in the initial years of the auditor–client relationship. Stated formally:

H3: For companies with short audit tenures, the likelihood of financial restatement is inversely related to audit fees.

While only short tenure effects have emerged in the empirical literature, con- cerns about long tenure independence problems persist. For example, regula- tors and interest groups argue that disproportionately large nonaudit fees that accumulate with audit tenure can diminish audit quality because they cre- ate incentive for auditors to acquiesce to client pressure (e.g., Conference Board, 2003; POB, 2000 ). The Sarbanes-Oxley Act (2002) addressed these entrenchment concerns by limiting the consulting services audit firms can pro- vide their clients and by requiring study of the mandatory audit firm rotation issue. 6 In its commissioned study, the GAO (2003) supported an earlier Con- ference Board (2003) call for audit committees to carefully consider auditor rotation when the auditor has long tenure and/or when the audit firm provides ‘‘significant nonaudit services’’ to the company. While noting the potentially high financial and institutional knowledge costs of mandatory rotation, the GAO acknowledged that both auditors under tenure limits and new auditors can bring a needed ‘‘fresh look’’ to financial reporting issues that long tenure auditors may lack. The extant literature provides mixed evidence about the association between audit and nonaudit fees and financial reporting quality. However, no study has empirically examined the long audit tenure/nonaudit service

5 Simon and Francis (1988) explain that audit fee data can only be used for an indirect test for lowballing. Proprietary audit cost and profit margin data are required for direct testing.

6 Mandatory audit firm rotation in the US has been discussed periodically over the past several decades. For example, the Metcalf Committee Report suggested in 1976 that the independence of auditors would be enhanced if audit firms were required to rotate clients after a set number of years (US Senate, 1976).

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link of concern to policymakers and regulators. Frankel et al. (2002) found a positive (negative) relationship between nonaudit (audit) fees and the like- lihood of reporting small earnings surprises and various abnormal accruals measures. As a result, they suggested the need to investigate the relationship between audit (nonaudit) fees and financial restatements. Alternatively, a number of studies (e.g., Ashbaugh et al., 2003; Chung and Kallapur, 2003; Raghunandan et al., 2003; Reynolds et al., 2004 ) fail to find signifi- cant links between fees and reporting quality. This study extends the litera- ture by specifically examining nonaudit fees and lengthy auditor–client relationships. Given persistent concerns that nonaudit fee entrenchment is associated with decreased financial reporting quality for long audit tenures, we expect the likelihood of financial restatement to be a function of the nonaudit fees earned by audit firms with long tenures. Stated formally,

H4: For companies with long audit tenures, the likelihood of financial restatement is positively related to nonaudit fees.

3. Design and sample

3.1. Model specification

We use a series of logistic regression models to test the hypotheses. To test the first hypothesis, the following model was estimated to assess whether the tenure effect findings in prior audit tenure studies (e.g., Geiger and Raghunan- dan, 2002; Johnson et al., 2002; Myers et al., 2003; Carcello and Nagy, 2004b ) are robust in the context of restatements:

RSTMT ¼ b 1 TENURE þ b 2 INDSPEC þ b 3 ADTFEE

þ b 4 NONADTFEE þ b 5 ZFC þ b 6 AGE

ð1 Þ

where RSTMT equals 1 if financial statements were restated, else 0; TENURE equals the length of the auditor–client relationship (in years); INDSPEC equals the audit firm’s industry marketshare based on total sales audited within 2-digit SIC code; ADTFEE equals the natural log of total audit fees; NONADTFEE equals the natural log of total nonaudit fees; ZFC equals Zmijewski’s (1984) financial condition index; AGE equals the length of time as a publicly-traded company (in years); and MERGER equals 1 if the company was involved in merger activity, else 0. Similar to several prior matched-sample studies in accounting (e.g., Archam- beault and DeZoort, 2001; Carcello and Nagy, 2004b; Menon and Williams, 2004 ), we estimate no-intercept models that address the independence assump- tion violation inherent in matched-sample designs. Hosmer and Lemeshow (2000) highlight that matched pair designs violate general logistic regression

þ b 7 MERGER þ e

J.D. Stanley, F. Todd DeZoort / Journal of Accounting and Public Policy 26 (2007) 131–159 139

assumptions because they involve creation of matched observations that are not independent. Therefore, we calculated paired differences (case minus control) for all variables and estimated no-intercept models using a constant (reflecting the difference between each matched case and control company) as the dependent variable. 7 Although restatements often involve multiple years, we measured all vari- ables in the first year restated. This approach is consistent with prior research (e.g., Richardson et al., 2003 ) and with the study’s objective to investigate financial reporting quality at the time the problems first arose, not when the problems were subsequently disclosed. TENURE was calculated using COMPUSTAT and annual proxy state- ments. 8 We reviewed proxy statements to minimize measurement error associ- ated with COMPUSTAT tenure measures. For example, COMPUSTAT may understate tenure because it records auditor data for companies only after they become public. Conversely, COMPUSTAT may overstate tenure because it can record up to three years of financial data (as usually presented in the S-1 registration statement and initial 10-K filing) for new IPO companies added to the database. Thus, first year auditors reporting on multiyear comparative statements for an IPO company may appear to have a three-year audit tenure. 9 Auditor changes attributable to audit firm mergers were coded as a continua- tion of the prior auditor. Several control variables are included in the model to enhance its ability to detect tenure differences between the restatement and control samples, reduce the possibility that the tenure results are a function of correlated omitted vari- ables, and enhance comparability with prior studies and our subsequent short tenure and long tenure models. First, we used an industry marketshare proxy for INDSPEC to control for differences in industry specialization among audit firms. Similar to prior studies (e.g., Carcello and Nagy, 2004a; Krishnan, 2003; Dunn and Mayhew, 2004 ), industry marketshare was calculated for each audit firm as the revenue of audit clients within a specific industry (denoted by 2-digit

7 Traditional logit models (with intercept) produced qualitatively similar results to those reported in the paper.

8 We used proxy statements to calculate TENURE if sufficient information was publicly disclosed. Otherwise, TENURE was calculated using COMPUSTAT. TENURE was truncated as of 1974 to minimize the influence of extreme observations and because COMPUSTAT does not contain auditor/opinion data for years prior to 1974. AGE also was truncated as of 1974 to be consistent with the TENURE calculation.

9 Mansi et al. (2004) note similar issues regarding tenure calculations based on COMPUSTAT data.

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SIC code) divided by the total revenue of all audited companies within that industry. 10 Second, ADTFEE and NONADTFEE were used because of con- cern about the impact of audit and nonaudit fees on auditor independence and audit quality (e.g., SEC, 2000 ). Fee data were collected from annual proxy statements corresponding to the first year restated. 11 Third, we included a financial condition measure (ZFC) to control for differences in distress levels between the restatement and control samples because management’s incentive to manipulate financial statements is likely associated with the health of the company ( Summers and Sweeney, 1998 ). Similar to prior studies (e.g., Carcello and Neal, 2000, 2003 ), we computed the ZFC index using coefficients from Zmijewski’s (1984) weighted probit model, where higher index values represent greater financial distress levels. AGE was used because company age is likely correlated with the length of the auditor–client relationship (i.e., a one-year increase in tenure is, by default, a one-year increase in age). Finally, we con- trolled for the presence of merger activity because Kinney et al. (2004) found that acquisition activity was positively related to the likelihood of restatement. Following Kinney et al. (2004) , MERGER was coded as a one if COMPU- STAT footnote data indicated the presence of merger activity, and zero otherwise. 12 To test H2 and H3 (H4), we estimated the following logit model using a matched sample of restatement companies and control companies with short (long) audit tenures and publicly available fee data to test for differences in audit firm industry marketshare and audit fees (nonaudit fees):

RSTMT ð ST = LT Þ ¼ b 1 INDSPEC þ b 2 ADTFEE

þ b 3 NONADTFEE þ b 4 ZFC þ b 5 AGE

þ b 6 MERGER þ e

ð2 Þ

10 The portfolio share ratio is an alternative to the industry marketshare ratio. The portfolio share approach focuses on an audit firm’s concentration in a specific industry and has a denominator equal to the sum of all clients’ revenue. We did not use this alternative measure because it is highly correlated with industry size and it tends to ignore smaller industries ( Neal and Riley, 2004). In addition, studies using the portfolio approach tend to lack variation in industry expertise when companies are matched on size and industry because industry size is highly correlated with this measure.

11 In 2000, the SEC required all registrants to disclose the most recent year’s audit and nonaudit fees in annual proxy statements filed on or after February 5, 2001. Therefore, fee data is only available for companies that restated 2000 financial statements or later.

12 We also considered a variety of alternative growth, complexity, risk, and governance control proxies that appear in other related studies. Specifically, we controlled for book-to-market, earnings-to-price, total asset change (%), presence of foreign operations, number of business segments, operating cash flow effects, number of audit committee meetings, and board size. None of these control variables affected the significance of our hypothesized variables.

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where RSTMT(ST), for short ( 63 years) tenure firms equals 1 if financial state- ments were restated, else 0; and RSTMT(LT), for long (P 5 years) tenure firms equals 1 if financial statements were restated, else 0. The remaining variables are as previously defined. While the literature fails to provide clear consensus on specific short tenure and long tenure cutoffs, we initially define short tenure in Model 2 as less than or equal to three years to be consistent with prior studies (e.g., Stice, 1991; Heninger, 2001; Geiger and Rag- hunandan, 2002; Johnson et al., 2002 ). In addition, we initially set the long ten- ure threshold in Model 2 at five years to be consistent with Myers et al. (2003) and Geiger and Raghunandan (2002) . 13 Subsequent sensitivity analysis will evaluate the robustness of our results to alternative short and long tenure definitions.

3.2. Sample development

Table 1 provides an overview of the restatement companies. The restatement sample was identified using a Boolean search (using the term ‘‘restatement near(5) financial’’) of annual SEC filings within 10-K Wizard for the five-year period 1/1/2000–12/31/2004. As indicated in Table 1 , Panel A, the search iden- tified 1599 unique company observations. For companies with restatements covering multiple years, we focused data collection and analysis on the first year of reported misstatement. We removed 756 companies with technical restatements to focus the sample on companies with annual restatements involving intentional or unintentional misapplications of GAAP. We also deleted 288 companies that did not use a Big 5/4 audit firm in the first year of restatement. The focus on Big 4/5 auditors helps control for possible audit quality differences between Big 5/4 and non-Big 5/4 audit firms (e.g., Becker et al., 1998 ) and manage the lack of tenure and industry specialization data available for many non-Big 5/4 firms. Three hundred fifty-one (351) companies were removed because of missing data (e.g., audit fees, nonaudit fees, and ZFC components). Finally, we removed 13 companies that had no reasonable non- restatement control company match (matching criteria described below). The sample screening process resulted in a final sample of 191 restatement companies. Table 1 , Panel B, describes the distribution of restatement companies by first fiscal year restated. The concentration of sample companies restating annual financial statements originally filed during 2000 or 2001 is due to the large

13 Myers et al. (2003, p. 785) described ‘‘three stages of the auditor–client relationship’’, using 5+ years as the long tenure stage, 3–4 years as a middle tenure stage, and 1–2 years as the short tenure stage. Their justification for this partitioning included reference to Congressional focus on five years as a potential target for mandatory firm rotation. Geiger and Raghunandan (2002) found that early tenure audit reporting failures ‘‘appear to taper off’’ after five years.

142 J.D. Stanley, F. Todd DeZoort / Journal of Accounting and Public Policy 26 (2007) 131–159

Table 1

Sample description

Panel A: Restatement sample development Initial number of unique company restatements Less: Interim and technical restatements Restatements involving non-Big 5/4 auditors Companies lacking proxy or financial statement data Companies without a suitable match

1,599

(756)

(288)

(351)

(13)

Final sample

191

First fiscal year restated

Full sample

Short tenure sample ( 6 3 years)

Long tenure sample ( P5 years)

Panel B: Distribution by first fiscal year restated

 

2000

74 (39%)

17 (34%)

41 (39%)

2001

69 (36%)

17 (34%)

42 (40%)

2002

36 (19%)

13 (26%)

15 (14%)

2003

11 (6%)

3 (6%)

5 (5%)

2004

1 (1%)

0 (0%)

1 (1%)

Total

191

50

104

Industry

Full sample

Short tenure sample ( 6 3 years)

Long tenure sample ( P5 years)

Panel C: Distribution by industry

Computers

39 (20%)

14 (28%)

19 (18%)

Durable manufacturers

43 (23%)

16 (32%)

18 (17%)

Extractive

5 (3%)

1 (2%)

2 (2%)

Financial

0 (0%)

0 (0%)

0 (0%)

Pharmaceuticals

11 (6%)

1 (2%)

9 (9%)

Retail

22 (12%)

4 (8%)

13 (13%)

Services

25 (13%)

5 (10%)

13 (13%)

Transportation

23 (12%)

8 (16%)

14 (13%)

Utilities

8 (4%)

0 (0%)

7 (7%)

Other

15 (8%)

1 (2%)

9 (9%)

Total

191

50

104

 

Mean

Med.

Std.

Min.

Max.

Panel D: Summary financial statistics for restatement companies Total assets ($ MM)

 

Full sample Short tenure sample ( 63 years) Long tenure sample (P5 years)

1619.65

252.87

6422.94

4.97

73501.00

676.70

251.11

1355.15

4.97

6260.59

1696.13

296.37

4814.28

5.87

42227.00

Total sales ($ MM) Full sample Short tenure sample ( 63 years) Long tenure sample (P5 years)

Net income ($ MM) Full sample Short tenure sample ( 63 years) Long tenure sample (P5 years)

919.02

177.71

2776.70

0.04

30293.00

480.24

144.24

844.86

1.72

4820.83

1065.78

256.00

3254.19

0.04

30293.00

90.69

3.45

512.85

5487.92

1232.00

138.42

16.32

380.43

2351.75

34.39

92.75

0.13

621.74

5487.92

612.00

J.D. Stanley, F. Todd DeZoort / Journal of Accounting and Public Policy 26 (2007) 131–159 143

Table 1 (continued)

 

Mean

Med.

Std.

Min.

Max.

Operating cash flow ($ MM) Full sample Short tenure sample ( 63 years) Long tenure sample (P5 years)

72.87

7.50

357.31

712.54

3681.00

0.54

2.24

76.42

301.73

169.68

72.63

10.31

264.00

712.54

1991.59

Tenure (years)

Full restatement sample

Full control sample

Panel E: Tenure distribution

1

38 (20%)

23 (12%)

2

13 (7%)

10 (5%)

3

14 (7%)

14 (7%)

4

15 (8%)

13 (7%)

5

9 (5%)

14 (7%)

6

16 (8%)

11 (6%)

7

14 (7%)

13 (7%)

8

8 (4%)

8 (4%)

9

16 (8%)

3 (2%)

10+

48 (25%)

82 (43%)

Total

191

191

This table presents descriptive information for the full sample of restatement companies, and for the short and long tenure subsamples. Short tenure (Long tenure) is defined as an auditor–client rela- tionship lasting less than or equal to three years (at least five years). Panel A presents the sample development process. Panel B presents the distribution of restatement companies by the first fiscal year restated. Panel C presents the distribution of restatement companies by industry. Following Raghunandan et al. (2003), industries are defined using SICs as follows: computers (7370–7379, 3570– 3579, 3670–3679), durable manufactures (3000–3999, excluding 3570–3579 and 3670–3679), extrac- tive (2900–2999, 1300–1399), financial (6000–6799), pharmaceuticals (2830–2836), retail (5000–5999), services (7000–8999, excluding 7370–7379), transportation (4000–4899), utilities (4900–4999). Panel D presents summary financial information for the restatement (sub)samples. Panel E presents fre- quency distributions for auditor tenure for the full sample of restatement and control companies.

percentage of filings restating multiple years and our focus on the first year restated. Table 1 , Panel C, presents the industry distribution results. Similar to Raghunandan et al. (2003) , the restatements are concentrated in the Com- puters and Durable Manufacturers industries. 14 Panel D of Table 1 presents summary financial statistics for the sample. The mean (median) total assets for the full sample is $1,619.65 ($252.87) million. 15

14 Financial institutions are not represented in the final sample because they generally lack classified balance sheet information needed for the computation of the ZFC control variable (e.g., current assets and current liabilities). 15 The extant restatement literature in accounting reveals considerable variance in both the number of restatements identified and the size of restatement firms across sample time period and selection criteria. For example, while our sample firms are similar in size to the sample firms in Kinney et al. (2004), Palmrose and Scholz (2004), Palmrose et al. (2004), and Desai et al. (2006), they are smaller than those examined by Raghunandan et al. (2003). Accordingly, we suggest the need for caution when generalizing results across restatement studies.

144 J.D. Stanley, F. Todd DeZoort / Journal of Accounting and Public Policy 26 (2007) 131–159

To test H1, we created a matched sample by matching each restatement company with a non-restatement control company based on year (the first year restated in the Form 10-K or Form 10-K/A), industry classification (SIC), company size (total assets), and audit firm size (Big 4/5) to control for systematic temporal and cross-sectional differences. 16 The control com- pany’s Form 10-K corresponding to the year on which the restatement and control company were matched, and all subsequent annual filings, were then reviewed to ensure that the match year’s Form 10-K had not been restated. Table 1 , Panel E, reports tenure frequency distributions for the full sample of restatement and control companies used to test H1. Although restatements occur across a range of audit tenures, the results indicate a relatively large number of restatements in the first year of audit tenure. The frequency results also show a relatively large number of control companies with extended (10+ years) audit tenures. To test the short tenure hypotheses (H2 and H3), we matched 50 restate- ment companies with audit tenures of three years or less with non-restate- ment companies with audit tenure of three years or less. For the long tenure hypothesis (H4), 104 restatement companies with audit tenures of at least five years were matched with non-restatement companies with audit tenures of five years or more. The matching criteria related to fiscal year, industry, company size, and auditor size also were imposed on these subsamples. 17

4. Results

4.1. Overall tenure results

The results in Table 2 , Panel A, present descriptive statistics for the 382 companies (191 restatement and 191 control) used to test H1. A t -test indicates

16 The matching protocol involved selecting a non-restatement company from the same four-digit SIC and within 15% in total assets. If no control company met these criteria, we then used three- digit or two-digit SIC match, respectively, and a maximum size deviation of ±30%. The restatement company was dropped from the sample if no control company was within ±30% of total assets and from the same two-digit SIC. Of the 191 restatement companies, 104, 25, and 62 were matched at the four-digit, three-digit, and two-digit SIC level, respectively. 173 (18) were matched on total assets within ±15% (±30%). 17 Audit firm tenure and company size (total assets) were not significantly different between restatement and non-restatement companies for any of the short and long tenure subsamples (p > 0.10 in all cases). Of the 50 short tenure restatement companies, 14, 11, and 25 were matched at the four-digit, three-digit, and two-digit SIC level, respectively. 30 (20) were matched on total assets within ±15% (±30%). Of the 104 long tenure restatement companies, 48, 14, and 42 were matched at the four-digit, three-digit, and two-digit SIC level, respectively. 90 (14) were matched on total assets within ±15% (±30%).

J.D. Stanley, F. Todd DeZoort / Journal of Accounting and Public Policy 26 (2007) 131–159 145

Table 2 Overall tenure results

 

Restatement sample (n = 191)

 

Control sample (n = 191)

 

Difference

 

Mean

Med.

Std.

Mean

Med.

Std.

Pred.

t

Panel A: Univariate results

 

TENURE

7.684

6.000

7.342

10.343

7.000

8.528

( (?) (?)

(

)

3.80

***

INDSPEC

0.210

0.193

0.075

0.208

0.202

0.069

)

0.37

ADTFEE

12.605

12.489

1.042

12.436

12.324

0.923

2.83

***

NONADTFEE

12.015

12.360

2.611

12.030

12.445

2.553

 

0.06

ZFC

1.534

2.238

3.165

2.466

2.758

1.963

(+)

3.67

***

AGE

11.529

8.000

8.687

12.005

9.000

9.281

( ) (+)

0.62

MERGER

0.262

0.000

0.441

0.157

0.157

0.365

 

2.82 ***

Variable

(1)

(2)

(3)

(4)

(5)

(6)

 

(7)

 

Panel B: Correlations among independent variables (Pearson above diagonal, Spearman below)

(1) TENURE

0.062

0.119

*

0.018

0.137

*

0.561 ***

0.089

(2) INDSPEC

0.061

0.091

0.020

0.001

0.062

0.077

(3) ADTFEE

0.147

**

0.053

0.267 ***

0.182 **

0.086

0.072

(4) NONADTFEE

0.020

0.123 *

0.313

***

0.075

0.036

0.034

(5) ZFC

0.192

***

0.008

0.127 *

0.028

 

0.080

0.081

(6) AGE

0.526 ***

0.010

0.104

0.046

0.112

 

0.019

(7) MERGER

0.079

 

0.091

0.047

0.036

 

0.094

0.002

 

Variable

Pred.

 

Coefficient

 

v 2

Panel C: Logistic regression results TENURE INDSPEC ADTFEE NONADTFEE ZFC AGE MERGER

   

***

H1 ( )

)

 

0.074

1.082

10.70

0.41

 

( (?) (?) (+) ( ) (+)

 

0.523

5.81

**

 

0.041

 

0.60

 

0.118

4.65

**

0.031

2.55

0.559

2.91 **

This table presents univariate and multivariate results from the full sample analysis. * , ** , *** represent significance at the .10, .05, and .01 level (one-tailed for results in the predicted direction), respectively. The variables are defined as follows:

RSTMT = 1 if financial statements were restated, else 0; TENURE = length of the auditor–client relationship (in years); INDSPEC = audit firm’s industry marketshare based on total sales audited within 2-digit SIC code; ADTFEE = natural log of total audit fees; NONADTFEE = natural log of total nonaudit fees; ZFC = Zmijewski’s (1984) financial condition index; AGE = length of time as a publicly-traded company (in years); and MERGER = 1 if the company was involved in merger activity, else 0. Panel A presents the mean, median, and standard deviation for the test variable of interest, TENURE, and the control variables. The mean log audit fees equal $298,045 (restatement sample) and $251,702 (control sample) in mean raw audit fees. The mean log nonaudit fees equal $165,215 (restatement sample) and $167,711 (control sample) in mean raw nonaudit fees. The tests of differences in means are based on paired-sample t-tests. Nonparametric Wilcoxon rank sum tests yield qualitatively similar results in all cases. Panel B presents Pearson (Spearman) correlations among the test and control variables above (below) the diagonal. Panel C presents estimation results from the following matched-sample logistic regression model (Model 1):

RSTMT ¼ b 1 TENURE þ b 2 INDSPEC þ b 3 ADTFEE þ b 4 NONADTFEE þ b 5 ZFC þ b 6 AGE þ b 7 MERGER þ e

Model v 2 = 37.290; p < 0.0001. Max-rescaled R 2 = 23.65%. n = 191 matched pairs.

146 J.D. Stanley, F. Todd DeZoort / Journal of Accounting and Public Policy 26 (2007) 131–159

that the restatement companies have a shorter mean audit tenure (7.684 years) than the non-restatement companies (10.343 years; p < 0.01). 18 In addition, the control variable results reveal that restatement companies pay higher audit fees (p < .01), have greater financial distress levels ( p < 0.01), and engage in more merger activity (p < 0.01) than non-restatement companies. Alternatively, the matched companies are similar in age, auditor industry specialization, and nonaudit fees ( p > 0.10 for all comparisons). Table 2 , Panel B, presents correlation results among TENURE and the control variables used in the multivariate analysis. Not surprising, the larg- est correlation is between TENURE and AGE (Pearson q = 0.561, p < 0.01). Otherwise, the correlation coefficients are generally small, suggest- ing that multicollinearity is not a problem. Furthermore, we estimated var- iance inflation factors (VIFs) for Model 1 and found the largest to be 1.53, well below the 10.00 threshold of concern recommended by Neter et al. (1996) . The logit results in Panel C of Table 2 indicate a significant TENURE model ( v 2 = 37.290; p < 0.0001). As hypothesized, the results indicate a signif- icant negative relation between TENURE and the likelihood of financial restatement (p < 0.01). 19 Consistent with the univariate analysis, the ADTFEE, ZFC, and MERGER coefficients are significant ( p < 0.05) and in the expected direction, while the INDSPEC, NONADTFEE, and AGE coefficients are insignificant. Collectively, these results provide support for H1 and suggest that prior ten- ure findings (e.g., Geiger and Raghunandan, 2002; Johnson et al., 2002; Myers et al., 2003; Carcello and Nagy, 2004b ) generalize to financial restatement con- texts. Furthermore, our findings of (1) larger audit fees, (2) similar nonaudit fees, and (3) increased merger activity for the restatement companies within our full sample is consistent with results documented in other recent restate- ment studies (e.g., Raghunandan et al., 2003; Kinney et al., 2004 ). However, the lack of significance for INDSPEC is inconsistent with evidence suggesting that auditor industry specialization is positively related to financial reporting quality (e.g., Balsam et al., 2003; Krishnan, 2003 ).

18 One-tail p-values are reported for tests involving directional predictions with results in the expected direction.

19 A number of tests were conducted to identify the effects of possibly influential observations. For example, we winsorized the continuous variables at the top and bottom one percent of the sample distribution. All results were qualitatively similar using these modified samples in the univariate and multivariate analysis. We also examined logistic regression diagnostic statistics (e.g., leverage values and DFBetas) and found no observations exerting undue influence on the hypothesis tests using the procedures outlined by Neter et al. (1996).

J.D. Stanley, F. Todd DeZoort / Journal of Accounting and Public Policy 26 (2007) 131–159 147

4.2. Short tenure results

Table 3 provides the results for H2 and H3, which predict that the likeli- hood of restatement by a short audit tenure company is inversely related to the audit firm’s industry specialization and audit fees, respectively. The uni- variate test results in Table 3 , Panel A, show that the audit firms represented in the short tenure restatement sample have less industry specialization than the audit firms in the control sample (p < 0.05). Consistent with the full sam- ple analysis discussed previously, the short tenure restatement firms exhibit greater financial distress than their control sample counterparts ( p < 0.01). No significant univariate differences emerge for ADTFEE, NONADTFEE, AGE, or MERGER. Table 3 , Panel B, presents correlations among the test and control variables included in Model 2. The largest correlations are between INDSPEC and ADTFEE (Pearson q = 0.348, p < 0.05) and ZFC and ADFEE (Pearson q = 0.366, p < 0.01). Analysis of VIFs for Model 2 indicates that the largest equals 1.29. Overall, this evidence suggests that multicollinearity is not a problem. The logit results in Table 3 , Panel C, indicate a significant short tenure model ( v 2 = 15.666; p = 0.016). Consistent with H2 and the univariate results, the INDSPEC coefficient is negative and statistically significant ( p < 0.05), suggesting the benefits of industry specialization for overcoming a lack of cli- ent-specific knowledge in initial audit engagement years. 20 In addition, after controlling for auditor industry specialization and financial distress, the results indicate a significantly negative ADTFEE coefficient ( p < 0.05). This finding provides support for the H3 prediction of an inverse relation between audit fees and likelihood of restatement, and is consistent with concerns that lowball audit pricing strategies jeopardize auditor independence and audit quality on new engagements.

4.3. Long tenure results

The results in Table 4 do not support our H4 prediction of a positive rela- tion between nonaudit fees and the likelihood of restatement for long audit tenure companies. The t-test results in Panel A of Table 4 indicate the restate- ment companies’ mean nonaudit fee ($207,109) is not statistically different than the non-restatement companies’ mean nonaudit fee ($216,642; p > 0.10). In contrast, the results reveal that the restatement companies pay

20 One of the industries represented in our short tenure sample has fewer than 30 companies. The results are qualitatively similar when the one matched-pair within this industry is dropped, suggesting small industries do not influence the industry specialization results ( Carcello and Nagy,

2004a).

148 J.D. Stanley, F. Todd DeZoort / Journal of Accounting and Public Policy 26 (2007) 131–159

Table 3 Short tenure industry specialization and audit fee results

 

Restatement sample (n = 50)

 

Control sample (n = 50)

 

Difference

Mean

Med.

Std.

 

Mean

 

Med.

Std.

Pred.

t

Panel A: Univariate results

 

INDSPEC

0.189

0.188

0.061

 

0.213

 

0.207

0.068

( ) (?) (+) ( ) (+)

)

(

1.88

**

ADTFEE

12.328

12.201

0.849

12.391

12.420

0.805

0.52

NONADTFEE

11.134

12.031

3.260

11.397

12.364

3.648

0.40

ZFC

0.481

2.201

4.332

2.235

2.726

2.167

2.76 ***

AGE

8.740

5.000

7.979

9.180

6.000

8.392

0.29

MERGER

0.280

0.000

0.454

0.280

0.000

0.454

 

0.00

Variable

(1)

(2)

(3)

(4)

(5)

(6)

 

Panel B: Correlations among independent variables (Pearson above diagonal, Spearman below)

 

(1) INDSPEC

0.348

**

0.279 **

.122

0.041

0.064

(2) ADTFEE

0.309 **

0.229

0.366 ***

0.025

 

0.236

*

(3) NONADTFEE

0.195

0.298

**

0.121

0.072

0.028

(4) ZFC

0.203

0.307

**

0.127

0.054

0.112

(5) AGE

0.068

0.037

0.107

0.088

0.258 *

(6) MERGER

0.111

0.240 *

 

0.072

 

0.038

.278 *

 

Variable

Pred.

Coefficient

 

v 2

Panel C: Logistic regression results INDSPEC ADTFEE NONADTFEE ZFC AGE MERGER

H2 ( ) H3 ( ) (?) (+) ( ) (+)

 

8.455

3.75

**

 

1.090

3.51

**

0.048

0.39

 

0.312

5.70 ***

 

0.014

 

0.17

 
 

0.157

0.09

This table presents univariate and multivariate results from the short tenure (63 years) sample analysis. * , ** , *** represent significance at the .10, .05, and .01 level (one-tailed for results in the predicted direction), respectively. The variables are defined as follows:

RSTMT = 1 if financial statements were restated, else 0; INDSPEC = audit firm’s industry marketshare based on total sales audited within 2-digit SIC code; ADTFEE = natural log of total audit fees; NONADTFEE = natural log of total nonaudit fees; ZFC = Zmijewski’s (1984) financial condition index; AGE = length of time as a publicly-traded company (in years); and MERGER = 1 if the company was involved in merger activity, else 0. Panel A presents the mean, median, and standard deviation for the test variables of interest, INDSPEC and ADTFEE, and the control variables. The mean log audit fees equal $225,934 (restatement sample) and $240,626 (control sample) in mean raw audit fees. The mean log nonaudit fees equal $68,460 (restatement sample) and $89,054 (control sample) in mean raw nonaudit fees. The tests of differences in means are based on paired-sample t -tests. Nonparametric Wilcoxon rank sum tests yield qualitatively similar results in all cases. Panel B presents Pearson (Spearman) correlations among the test and control variables above (below) the diagonal. Panel C presents estimation results from the following matched-sample logistic regression model (Model 2):

RSTMT ¼ b 1 INDSPEC þ b 2 ADTFEE þ b 3 NONADTFEE þ b 4 ZFC þ b 5 AGE þ b 6 MERGER þ e

Model v 2 = 15.666; p = 0.016. Max-rescaled R 2 = 35.86%. n = 50 matched pairs.

J.D. Stanley, F. Todd DeZoort / Journal of Accounting and Public Policy 26 (2007) 131–159 149

higher mean audit fees ($329,062) than the non-restatement companies ($268,606; p < 0.01). The correlation results presented in Table 4 , Panel B, show relatively small associations among the test and control variables included in Model 2, with the exception of ADTFEE and NONADTFEE (Spearman q = 0.408, p < 0.01). As with the other models, analysis of VIFs suggested that multicollinearity was not a problem. 21 The logit results in Table 4 , Panel C, indicate that the long tenure nonaudit fee model is significant (v 2 = 14.295; p = 0.027). Similar to the univariate results, the multivariate results do not show a significant coefficient for NON- ADTFEE ( p > 0.10). The significant positive coefficients for ADTFEE (p < 0.01) and MERGER ( p < 0.05) suggest higher audit fees and a greater likelihood of merger activity for long tenure restatement companies. While contrary to the short tenure prediction and findings, the long tenure audit fee result is consistent with the results in Kinney et al. (2004) . Specifically, Kin- ney et al. (2004) found that restatement firms paid larger audit fees than non- restatement firms and conjectured that the larger fees could reflect auditors’ response to heightened ex ante misstatement risk (i.e., additional audit effort and/or fee premiums). When considered with the significant short tenure indus- try specialization (H2) result, the insignificant long tenure INDSPEC effect helps highlight the importance of industry specialization in managing a lack of client-specific knowledge inherent in new audit engagements.

4.4. Sensitivity analysis

We conducted a series of sensitivity tests to evaluate the robustness of our results. We first examined the overall tenure results that support H1. To eval- uate whether the TENURE results are capturing client characteristics linked to both auditor changes and financial reporting quality (e.g., DeFond and Subr- amanyam, 1998 ), we re-estimated Model 1 after removing restatement and control companies with audit tenures of one year or less (i.e., first-year audit engagements). The results (not tabulated) show that TENURE remains nega- tive and significant (coefficient = 0.051, p < 0.05) after deleting the initial year audit engagement companies. We also dropped AGE from the model because of the correlation between TENURE and the number of years the company has been publicly traded. Again, we find that TENURE remains negative and significant (coefficient = 0.054, p < 0.01).

21 Given concern about correlation between audit and nonaudit fees (e.g., Whisenant et al., 2003), we also alternatively dropped ADTFEE and NONADTFEE from the models to test whether fee correlations affect the multivariate results reported throughout the paper. The revised NONADT- FEE (ADTFEE) results are qualitatively similar to those reported when ADTFEE (NONADT- FEE) is excluded.

150 J.D. Stanley, F. Todd DeZoort / Journal of Accounting and Public Policy 26 (2007) 131–159

Table 4 Long tenure nonaudit fee results

 

Restatement sample (n = 104)

 

Control sample (n = 104)

 

Difference

 

Mean

Med.

Std.

Mean

 

Med.

Std.

Pred.

t

Panel A: Univariate results

 

NONADTFEE

12.241

12.437

2.398

12.286

 

12.357

1.645

(+) ( ) (?) (+) ( ) (+)

0.21

INDSPEC

0.217

0.196

0.081

0.214

0.219

0.070

0.31

ADTFEE

12.704

12.634

1.022

12.501

 

12.378

0.904

2.79

***

ZFC

2.015

2.261

2.519

2.110

2.748

3.469

0.22

AGE

12.913

10.000

8.473

14.038

11.000

8.859

1.17

 

MERGER

0.221

0.000

0.417

0.144

0.000

0.353

 

1.52 *

Variable

(1)

(2)

(3)

 

(4)

(5)

 

(6)

 

Panel B: Correlations among independent variables (Pearson above diagonal, Spearman below)

 

(1) NONADTFEE

0.012

0.283 ***

0.124

0.117

 

0.185 *

(2) INDSPEC

0.022

0.061

0.120

0.164 *

0.071

(3) ADTFEE

0.408 ***

0.002

0.133

0.052

0.122

(4) ZFC

0.141

0.164 *

0.131

0.046

0.010

(5) AGE

0.096

0.083

0.025

0.104

0.006

(6) MERGER

0.115

0.142

 

0.142

 

0.087

0.009

 

Variable

Pred.

Coefficient

 

v 2

Panel C: Logistic regression results NONADTFEE INDSPEC ADTFEE ZFC AGE MERGER

H4 (+) ( ) (?) (+) ( ) (+)

 

0.139

1.39

 
 

1.080

0.24

0.960

8.83

***

 

0.007

0.02

0.022

 

0.92

 

0.850

3.87 **

This table presents univariate and multivariate results from the long tenure (P 5 years) sample analysis. * , ** , *** represent significance at the .10, .05, and .01 level (one-tailed for results in the predicted direction), respectively. The variables are defined as follows:

RSTMT = 1 if financial statements were restated, else 0; NONADTFEE = natural log of total nonaudit fees; INDSPEC = audit firm’s industry marketshare based on total sales audited within 2-digit SIC code; ADTFEE = natural log of total audit fees; ZFC = Zmijewski’s (1984) financial condition index; AGE = length of time as a publicly-traded company (in years); and MERGER = 1 if the company was involved in merger activity, else 0. Panel A presents the mean, median, and standard deviation for the test variable of interest, NONADTFEE, and the control variables. The mean log audit fees equal $329,062 (restatement sample) and $268,606 (control sample) in mean raw audit fees. The mean log nonaudit fees equal $207,109 (restatement sample) and $216,642 (control sample) in mean raw nonaudit fees. The tests of differences in means are based on paired-sample t-tests. Nonparametric Wilcoxon rank sum tests yield qualitatively similar results in all cases, except for ZFC, which is larger for the restatement sample (p < 0.10). Panel B presents Pearson (Spearman) correlations among the test and control variables above (below) the diagonal. Panel C presents estimation results from the following matched-sample logistic regression model (Model 2):

RSTMT ¼ b 1 NONADTFEE þ b 2 INDSPEC þ b 3 ADTFEE þ b 4 ZFC þ b 5 AGE þ b 6 MERGER þ e

Model v 2 = 14.295; p = 0.027. Max-rescaled R 2 = 17.12%. n = 104 matched pairs.

J.D. Stanley, F. Todd DeZoort / Journal of Accounting and Public Policy 26 (2007) 131–159 151

We also assessed whether the reported short tenure and long tenure results are sensitive to alternative tenure cutoffs and alternative industry specialization and fee measures. For example, we investigated whether the three-year short tenure industry specialization and audit fee effects remained significant using a two-year short tenure cutoff. The literature (e.g., Loebecke et al., 1989; AICPA, 1992 ) provides some evidence that audit and financial reporting prob- lems are most likely to occur during the initial two years of the auditor–client relationship. 22 The results in Table 5 , Panel A, indicate that INDSPEC and ADTFEE remain negative and significant at the .05 level using a matched sam- ple of 31 restatement and non-restatement companies with audit tenures of no more than two years. Furthermore, the INDSPEC and ADTFEE coefficients increased by approximately 70% and 50% in the re-estimated model, respec- tively, when compared to the coefficients estimated using a sample with a three-year tenure cutoff. These results suggest that the positive effects of indus- try specialization and audit fees on financial reporting quality for short tenure engagements are not driven by audit firms with the longest tenure within the sample. In addition, we estimated the two-year and three-year models using alternative industry specialization proxies based on total assets audited within an industry ( Carcello and Nagy, 2004a ) and total number of clients within the industry ( Balsam et al., 2003 ). The results (not tabulated) are qualitatively sim- ilar using these alternative proxies. Next, we evaluated whether the nonaudit fee (H4) results depend on the spe- cific long tenure threshold used. Specifically, although prior studies (e.g., Myers et al., 2003 ) have used five-year long tenure thresholds, the literature also includes studies using thresholds of up to nine-years (e.g., Johnson et al., 2002; Carcello and Nagy, 2004b ). Accordingly, we re-estimated the initial five-year long tenure model (Model 2) using longer thresholds of seven and nine years. As the results in Table 5 , Panel B, indicate, NONADTFEE remained insignificant in both cases, suggesting our reported results are not sensitive to long tenure threshold. To assess whether our long tenure fee results are sensitive to using nonaudit fees as a proxy for auditor independence, we conducted additional analysis using the ratio of nonaudit fees to audit fees. Despite concerns that fee ratios ignore fee magnitude ( Reynolds et al., 2004 ) and are difficult to interpret (Kinney et al., 2004 ), the SEC (2000) listed the ratio of nonaudit fees to audit fees as an important indicator for assessing audit firm independence. Consis- tent with the nonaudit fee results, the results in Table 5 , Panel C, indicate that

22 The AICPA’s Quality Control Inquiry Committee found that allegations of audit failures occur almost three times as often during this initial two-year period (AICPA, 1992). Similarly, Loebecke et al. (1989) found that audit partners report that approximately one-third of accounting irregularities and management fraud encountered occur during the first two years of the audit engagement.

152 J.D. Stanley, F. Todd DeZoort / Journal of Accounting and Public Policy 26 (2007) 131–159

Table 5 Supplemental logistic regression results

Variable

Pred.

Coefficient

 

v 2

Panel A: Alternative short tenure definition (6 2 years)

 

INDSPEC

H2 ( ) H3 ( ) (?) (+) ( ) (+)

 

14.349

 

4.23

**

ADTFEE

1.625

3.63

**

NONADTFEE

0.143

1.42

ZFC

 

0.345

3.49 **

AGE

0.054

0.98

MERGER

 

0.183

0.06

Model v 2 = 14.715; p = 0.023 Max-rescaled R 2 = 50.39%

n

= 31 matched pairs,

Variable

P7 years

 

P9 years

 

Pred.

Coefficient

v 2

Coefficient

v 2

Panel B: Alternative long tenure definitions ( P7 years and P 9 years)

NONADTFEE

0.153

1.34

0.183

1.06

INDSPEC

ADTFEE

ZFC

AGE

MERGER

H4 (+) ( ) (?) (+) ( ) (+)

 

2.899

1.14

1.448

0.20

0.880

6.73

***

 

0.784

3.46 **

 

0.015

0.07

0.042

0.30

0.012

0.24

0.009

0.07

 

0.962

3.32 **

 

0.786

1.56

Model v 2 ( p-value):

11.033 (0.087)

 

5.729 (0.454)

Max-rescaled R 2 :

18.02%

 

14.71%

n

matched pairs:

76

49

Variable

P 5 years

P 7 years

 

P 9 years

Pred.

Coefficient v 2

Coefficient v 2

 

Coefficient v 2

 

Panel C: Alternative long tenure independence proxy (fee ratio)

FEERATIO

H4 (+) ( ) (+) ( ) (+)

0.039

0.37

0.004

0.00

0.051

0.23

INDSPEC

0.406

0.04

2.039

0.62

0.943

0.09

ZFC

0.007

0.02

0.002

0.00

0.002

0.00

AGE

0.023

1.20

0.012

0.21

0.015

0.21

MERGER

0.600

2.26 *

0.642

1.84

0.592

1.09

Model v 2 ( p-value): 4.100 (0.535)

 

2.802 (0.731)

 

1.680 (0.891)

Max-rescaled R 2 :

5.15%

4.83%

4.49%

n

matched pairs:

104

76

49

Variable

 

P 5 years

P 7 years

 

P 9 years

 

Pred.

Coefficient v 2

Coefficient v 2

Coefficient v 2

Panel D: Alternative long tenure independence proxy (total fee)

TOTALFEE

H4 (+)

0.501

INDSPEC

( )

0.640

ZFC

(+)

0.007

AGE

( )

0.025

MERGER

(+)

0.591

4.70

0.09

0.02

1.40

2.15 *

**

 

0.488

3.50 **

0.366

1.53

2.469

0.87

0.971

0.10

0.019

0.13

0.010

0.02

0.012

0.25

0.011

0.11

 

0.591

1.52

0.478

0.69

J.D. Stanley, F. Todd DeZoort / Journal of Accounting and Public Policy 26 (2007) 131–159 153

Table 5 (continued)

Variable

P 5 years

P7 years

P9 years

 

Pred.

Coefficient

v 2

Coefficient

v 2

Coefficient

v 2

Model v 2 ( p-value):

8.843 (0.116)

 

6.619 (0.251)

3.075 (0.689)

Max-rescaled R 2 :

10.87%

11.12%

8.11%

n matched pairs:

104

76

49

This table presents supplemental multivariate results. * , ** , *** represent significance at the .10, .05, and .01 level (one-tailed for results in the predicted direction), respectively. The variables are defined as follows:

RSTMT = 1 if financial statements were restated, else 0; ADTFEE = natural log of total audit fees; NONADTFEE = natural log of total nonaudit fees; FEERATIO = ratio of total nonaudit fees to total audit fees; TOTALFEE = natural log of total fees; INDSPEC = audit firm’s industry marketshare based on total sales audited within 2-digit SIC code; ZFC = Zmijewski’s (1984) financial condition index; AGE = length of time as a publicly-traded company (in years); and MERGER = 1 if the company was involved in merger activity, else 0. Panel A presents the estimation results from Model 2 (presented in Table 3) using the audit fee independence proxy and an alternative short tenure sample, where short tenure is defined as less than or equal to two years. Panel B presents the estimation results from Model 2 (presented in Table 4) using the original nonaudit fee independence proxy and two alternative long tenure samples, where long tenure is defined as at least seven and nine years. Panel C presents the estimation results from the augmented Model 2 using the ratio of nonaudit to audit fees as the independence proxy and the three long tenure samples, where long tenure is defined as at least five, seven, and nine years. Panel D presents the estimation from the augmented Model 2 using total fees as the independence proxy and the three long tenure samples.

the ratio of total nonaudit fees to audit fees is not significantly related to the likelihood of restatement for our five-, seven-, or nine-year samples. This find- ing further supports our conclusion that large nonaudit fees do not appear to be linked to adverse financial reporting outcomes requiring subsequent correc- tion and restatement. The magnitude of total fees also has been examined in previous studies assessing auditor independence (e.g., Frankel et al., 2002; Ashbaugh et al., 2003 ). Several papers (e.g., Beck et al., 1988; Magee and Tseng, 1990; Bazer- man et al., 1997 ) suggest that a fee-based economic bond between auditor and client threatens auditor independence. This perspective posits that all client payments to the auditor (including audit and nonaudit fees) strengthen this bond and undermine auditor independence. Accordingly, we use total fees as an alternative fee-based independence proxy for long tenure firms to facilitate comparison with prior research. The results in Table 5 , Panel D, indicate a sig- nificant positive association between total fees and the likelihood of restate- ment ( p < 0.05) for the five-year and seven-year tenure samples. However, we highlight that this total fee effect appears to be driven by the magnitude of

154 J.D. Stanley, F. Todd DeZoort / Journal of Accounting and Public Policy 26 (2007) 131–159

audit fees given the significant ADTFEE and insignificant NONADTFEE results presented in Table 4 , Panel C, and Table 5 , Panel B. Audit fees arguably hinder auditor independence less than nonaudit fees (SEC, 2000 ). Further- more, regulators do not appear to be concerned about the potential adverse effect of large audit fees on the auditor’s independence ( Kinney et al., 2004 ). Accordingly, we question whether auditor independence is the construct under- lying the total fee effect on the likelihood of restatement within our sample companies. 23

5. Discussion and conclusion

This study provides some initial empirical evidence on the link between financial restatements, audit tenure, and tenure-related proxies for audit firm expertise and independence. Consistent with prior audit tenure effect studies (e.g., Geiger and Raghunandan, 2002; Johnson et al., 2002; Carcello and Nagy, 2004b; Ghosh and Moon, 2005 ), we find evidence of an inverse relation between audit tenure and financial restatement. Decomposition of the overall tenure effect reveals that the likelihood of restatement is inversely related to the audit firm’s industry marketshare and audit fees for companies with short audit tenures. The long tenure results indicate no significant relation between nonaudit fees and likelihood of restatement. Collectively, these results have a number of research, policy, and practice implications. From a research perspective, the results extend the tenure effects literature in two primary ways. First, this study provides evidence that audit tenure problems documented in other financial reporting domains (e.g., accrual accounting) are robust and generalize to relatively objective financial restate- ment events. Second, this study provides an initial empirical examination of underlying expertise and independence factors that have only been suggested to date. The short tenure industry specialization results are consistent with con- cerns about reduced audit quality due to a lack of client-specific knowledge on new audit engagements. While this inference is supported further by the insig- nificant industry specialization effect in long tenure companies, future research is needed to better distinguish between specialization and learning curve effects in new audit engagements. The short tenure audit fee results provide initial support for prior concerns about adverse lowballing effects (e.g., Simon and Francis, 1988; Ettredge and Greenberg, 1990; Deis and Giroux, 1996 ). Specifically, our multivariate results support regulator concern that lowballing impairs audit quality during the ini-

23 We also evaluated the roles of the nonaudit fee ratio and total fees in determining the likelihood of restatement for the full sample. Neither variable is significant when evaluated individually in lieu of ADTFEE and NONADTFEE in Model 1. Otherwise, the results were qualitatively similar to those reported in Table 2, Panel C.

J.D. Stanley, F. Todd DeZoort / Journal of Accounting and Public Policy 26 (2007) 131–159 155

tial years of an audit engagement (e.g., AICPA, 1978; SEC, 2000 ). This short tenure result is particularly prominent given our findings of higher audit fees for restatement firms in the full sample and long tenure sample. Given the rel- atively small short tenure sample, future research is needed to test whether this audit fee effect is generalizable to other settings. Other than the results pre- sented in this study, very little empirical data exists on the effects of lowballing on audit quality (Watkins et al., 2004 ). We also suggest the need for future research to evaluate potential audit quality tradeoffs involving short tenure industry specialization gains and lowballing losses. From a policy perspective, the results do not support calls for mandatory audit firm rotation and regulatory concern that nonaudit services hinder audit firm independence and audit quality in the later years of the auditor–client rela- tionship (e.g., Sarbanes-Oxley Act, 2002; SEC, 2003 ). In addition, the short tenure industry specialization findings support concerns about the potential costs of mandatory audit firm rotation (e.g., PwC, 2002; GAO, 2003 ). More specifically, our results highlight the risk of decreased audit quality in forced auditor changes where access to a new auditor with specialized knowledge is limited. These findings also support concerns among large public accounting firms and Fortune 1000 companies that auditor changes increase the risk of audit failure in early audit years because auditors may fail to detect material misstatement while they are acquiring ‘‘the necessary knowledge of the com- pany’s operations, systems, and financial reporting practices’’ (GAO, 2003, p. 6 ). The short tenure audit fee results provide indirect support for the long- standing regulatory concern over the adverse effects of lowballing. Finally, from a practice perspective, the findings of this study and prior studies (e.g., Dunn and Mayhew, 2004; Carcello and Nagy, 2004a ) emphasize the importance of audit firm industry specialization. Collectively, our results suggest that specialization has the potential to compensate for a lack of cli- ent-specific knowledge during the initial years of the audit engagement. While several accounting studies suggest concern about the learning curve associated with new audit clients (e.g., Beck et al., 1988; Stice, 1991; Geiger and Raghun- andan, 2002 ; Johnson et al., 2002 ), future research should continue to evaluate the extent that industry specialization at the firm and office level (e.g., Francis et al., 2005 ) can mitigate adverse learning curve effects. The results should be evaluated in the context of the study’s limitations. First, the possibility of measurement error exists given our proxies and specific measures. For example, despite the SEC’s (2003) issuance of new fee disclosure rules designed to improve consistency and transparency, companies continue to have discretion when reporting and categorizing audit and nonaudit fees in annual proxy statements ( Weil and Rapoport, 2003 ). Second, despite our matching process and use of various controls in the study, correlated omitted variables may affect the results. Specifically, we recognize the possibility of end- ogeneity (e.g., DeFond et al., 2002; Whisenant et al., 2003 ) with respect to

156 J.D. Stanley, F. Todd DeZoort / Journal of Accounting and Public Policy 26 (2007) 131–159

auditor tenure. To the extent our tenure variable reflects underlying auditor change decisions, consideration of the study’s implications should include the possibility that audit tenure may respond to an unspecified omitted variable or simultaneously to changes in the likelihood of restatement.

Acknowledgements

We gratefully acknowledge the helpful comments and suggestions received from Debbie Archambeault, Mark Beasley, Dana Hermanson, Gary Hol- strum, Rich Houston, Rob Ingram, Karen Maguire, Mary Stone, Gary Taylor, and workshop participants at The University of Alabama and the 2004 Amer- ican Accounting Association Annual Meeting.

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