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Auditor Tenure and the Ability to Meet or Beat Earnings Forecasts
Larry R. Davis, Billy S. Soo, and Gregory M. Trompeter
This paper investigates the relation between auditor tenure and earnings management. The effects of mandatory auditor rotation on audit quality and financial reporting quality have been the subject of a long and often heated debate among regulators, investors, and the accounting profession. Recent interest in mandatory rotation stems from its possible use as a means of redressing the problems that led to the financial frauds of the early 21st century. In a 2003 report, the General Accounting Office (now the Government Accountability Office) (GAO) conducted a study on mandatory rotation and chose not to support its implementation. However, the GAO made clear that it might recommend mandatory rotation in the future if auditor independence concerns persisted in the post-Sarbanes Oxley (SOX) period.
Prior research investigating the relation between tenure and audit quality has focused on the pre-SOX period and reports conflicting results. Some have found that audit quality is lower in the early years of the auditor–client relationship while others find no association. Most germane to this paper are studies investigating the relation between tenure and earnings management. Both a 2002 and a 2003 study find that absolute discretionary accruals decrease with tenure. Further, the 2003 paper finds that positive (negative) discretionary accruals decrease (increase) with auditor tenure. Similarly, a later study reports higher levels of earnings management in the early years of the auditor–client relationship, but find that the association between tenure and accruals is affected by client size and the level of nonaudit fees. Related work examines capital market perceptions of auditor tenure and finds evidence consistent with the market rewarding increasing auditor tenure.
Our analyses address regulators’ concerns that, as tenure increases, auditors’ tolerance for earnings management increases and results in registrants being able to more frequently meet analysts’ forecasts. Specifically, we identify registrants who meet or beat analysts’ earnings forecasts who would have missed analysts’ targets in the absence of discretionary accruals. We then determine whether auditor tenure is associated with the frequency with which such registrants are able to use discretionary accruals to meet or beat forecasts.
Unlike previous studies that only use the presence of large discretionary accruals or earnings surprises as evidence of earnings management, we use a more restrictive definition by requiring a firm to have not only the desired reporting outcome, but also the incentive and means to successfully achieve it. More specifically, we require a firm to have nondiscretionary earnings (i.e., net income less discretionary accruals) that are below the consensus analyst forecast (the incentive). The firm must then report sufficient positive discretionary accruals (the means) that, when added to nondiscretionary earnings, allow reported income to be equal to or greater than the analyst forecast (the desired outcome). Thus, we consider an observation to provide evidence consistent with earnings management only if the observation represents a firm that met or beat its earnings target and would have missed that target in the absence of discretionary accruals.
Our sample includes 23,748 I/B/E/S firm-years over the period 1988–2006. In the pre-SOX period (1988–2001), we observe an increase in the use of discretionary accruals to meet or beat earnings forecasts in both the early and the later years of the auditor–client relationship. This nonlinear relation between tenure and audit quality may explain, at least in part, the mixed findings observed in earlier studies. In the post-SOX period (i.e., 2002–6), we do not observe a relation between auditor tenure and discretionary accruals in either the early or the later years of the auditor–client relationship. This is consistent with the results of other recent studies that find that earnings management has decreased in the post-SOX period. Our findings contribute to the literature as follows. Our pre-SOX results provide the first evidence consistent with a relation between long-term audit firm tenure and deteriorating audit quality in the form of a client’s ability to use discretionary accruals to meet or beat forecasts. Second, our results provide evidence consistent with recent findings that there was a decline in earnings management following the passage of SOX. This change is consistent with increased audit quality, or a decline in managers’ attempts to manage earnings, or both. What remains to be seen is whether this change is long-lasting or merely transitory. Third, our results with respect to long tenure indicate that the tenure-related deterioration in audit quality occurs at a later point in the auditor tenure relation than that considered in prior research. We find statistically significant evidence of a long-term tenure effect only after the 14th year. Prior studies define long tenure as more than 8 years and fail to find any evidence of a long-term tenure effect. This suggests that the inability of prior studies to detect a long tenure effect may be due to their specification of what constitutes long tenure. Finally, we provide a more direct test of the relation between tenure and earnings management. Previous studies implicitly assume increased levels of accruals to be evidence of greater earnings management. By examining the extent to which discretionary accruals are associated with meeting or beating forecasts, our approach more directly examines whether tenure is associated with firms’ increased ability to manage earnings.