After periods of high-profile corporate accidents, such as frauds and bankruptcies, authoritiess and regulators tend to turn their attending to the hearers function in the corporate fiscal coverage procedure ( U.S. Governmental Accounting Office ( GAO ) , 1996 ) . The accounting dirts sing Enron and WorldCom were such events and led to renewed concerns sing hearer term of office – which is best described as the length of the relationship between the hearer and the client – and its possible consequence on the quality of an audit ( Johnson et al. , 2002 ) . It was proposed that compulsory audit-firm rotary motion could be a manner to better the quality of fiscal coverage ( Johnson et al. , 2002 ) . The Sarbanes-Oxley Act, a U.S. jurisprudence which came into force in 2002, introduced major alterations to the ordinance of fiscal pattern and corporate administration and requested a survey of the possible effects of this compulsory audit rotary motion ( Myers et al. , 2005 ) . However, this resulted in a negative advice sing the execution of the compulsory audit rotary motion ( GAO, 2003 ) .
The proposal besides caused a turning involvement in this topic among faculty members and look intoing the consequence of hearer term of office on audit quality became the chief aim of several surveies ( e.g. Johnson, Khurana and Reynolds, 2002 ; Myers et al. , 2003 ) . Despite the considerable involvement for the subject, the grounds remains inconclusive and anterior literature has evolved into two opposing positions sing the consequence of hearer term of office on audit quality ( Geiger and Raghunandan, 2002 ) . On the one manus there is literature back uping a positive association between hearer term of office and audit quality ( Carcello and Nagy, 2004 ; Geiger and Raghunandan, 2002 ; Johnson et al. , 2002 ; Myers et al. , 2003 ) , while on the other manus research workers concluded that hearer term of office has a negative influence on the quality of an audit ( Copley and Doucet, 1993 ; Davis et al. , 2000 ; Vanstraelen, 2000 ) .
When concentrating on hearer independency specifically, the consequences of other surveies show that the influence of term of office is strongly affected by the personal connexion of an hearer with the client ( Bamber and Iyer, 2007 ; Bazerman et al. , 1997, 2002 ; Bruynseels and Cardinaels, 2012 ) . In add-on, the main executive officer ( CEO ) of the client house is considered an of import portion of the relationship between an hearer and its client. Furthermore, the length of this relationship leads to an addition in fond regard by both parties. This sense of fond regard could in turn negatively affect audit quality ( Seabright et al. , 1992 ) .
In line with these statements, the relationship between the hearer and the Chief executive officer might hold a important influence on audit quality. The current survey will therefore dressed ore on the auditor-client relationship sing its influence on the quality of fiscal coverage. Specifically, the chief aim of this survey is to measure the consequence of the length of the direct relationship between an hearer and a Chief executive officer on audit quality.
Prior research on the topic focussed chiefly on the relation between hearer term of office and audit quality. Since the grounds remains inconclusive, the current survey purposes to derive farther penetration into this affair. It specifically contributes to bing literature by agencies of including the length of the relationship between hearer and CEO as a possible determiner of audit quality, which has non been examined before.
Hearers provide independent confirmation of fiscal statements and as a consequence their quality contributes to the credibleness of fiscal revelation ( Mansi et al. , 2004 ) . Harmonizing to the research of Mansi, Maxwell and Miller ( 2004 ) , investors peculiarly value the information and insurance function of an hearer. Furthermore they found direct grounds that investors attach value to scrutinize term of office ( Mansi et al. , 2004 ) . Similarly, Ghosh and Moon ( 2005 ) focussed on investors, independent evaluation bureaus and fiscal analysts as primary users of fiscal statements. They found that these users give a higher dependability to audited fiscal statements when the hearer term of office is longer. This anterior research shows that users of fiscal statements have certain premises and utilize these in important extent when doing determinations, even though the grounds is, so far, inconclusive. More insight in the topic and the determiners of audit quality could therefore significantly increase the quality of determination devising.
In order to analyse the auditor-client relationship, information is collected from public companies in the United States of America. To garner information on both hearer and CEO term of office, information is obtained from two different databases, Compustat and Execucomp. In order to proxy for audit quality, this thesis uses an unnatural on the job capital accumulations step as proposed by DeFond and Park ( 2001 ) . By agencies of arrested development analysis, the relationship between hearer and CEO and audit quality is analyzed in order to prove the hypothesis that a longer coaction between an hearer and a CEO reduces audit quality.
The consequences from the multiple arrested development analysis are undistinguished and therefore supply no grounds that the length of the relationship between an hearer and a CEO reduces audit quality.
The balance of the thesis is structured as follows. The 2nd chapter provides an overview of related literature and ends with the hypothesis development. The methodological analysis is presented in the 3rd subdivision. It provides the information aggregation, sample choice, the research method and the variable descriptions. Thereafter, the consequences are discussed in subdivision four. This portion provides the descriptive statistics, correlativities and displays the consequences of the analyses and eventually tests the hypothesis. Section five concludes the thesis, including the deductions of the survey for pattern and
for future research.
2. Literature Review and Hypothesis Development
As a first measure, this chapter provides a literature reappraisal to get necessary penetrations into the subject at manus followed by the development of the hypothesis. To get down off, the construct of audit quality is explained and later its connexion with hearer term of office and CEO term of office. Section 2.2 and 2.3 describe how audit quality is affected by hearer and CEO term of office, severally. The subdivision ends with the development of the hypothesis in subdivision 2.4.
2.1 Audit Quality
As the chief subject of this research, this subdivision aims to clear up the construct of audit quality to supply a clear thought of the subject.
The chief aim of fiscal statements is to pass on fiscal information to stakeholders. Since these statements are prepared by company direction, it gives rise to information dissymmetry and possible struggles of involvement between direction and those outside an entity. An audit of fiscal statements provides independent confirmation of the study and could therefore better the quality of the reported fiscal information ( Dopuch and Simunic, 1982 ; Watts and Zimmerman, 1986 ) and heighten the information quality about the value of traded securities ( Ronnen, 1996 ) . Acknowledging the important influence hearers have on the procedure of fiscal coverage, Antle and Nalebuff ( 1991 ) view the fiscal statements as a joint result of the company direction and the audit house. Furthermore, as an audit adds credibleness it increases the investor ‘s trust in the operation of the capital market ( Van der Plaats, 2000 ) . The ability of an hearer to better the quality of fiscal coverage is best described by DeAngelo ( 1981b ) . She defines audit quality as “ the market-assessed articulation chance that a given hearer will both ( a ) discover a breach in the client ‘s accounting system and ( B ) study the breach ” ( DeAngelo, 1981b, p. 186 ) . The first feature, the ability to detect breaches in the accounting system, is by and large defined as competency and the coverage of those breaches relates to the independency of an hearer.
Gunny, Krishnan and Zhang ( 2007 ) depict two types of breaches that could be discovered during the audit procedure: an audit lack, such as a failure to obtain and measure important grounds or failure to execute sufficient processs, and a serious lack, which consequences when an hearer fails to observe a going from the needed coverage criterions that could ensue in a restatement of the fiscal study. If material misstatements are identified by the hearer and later corrected, the quality of the fiscal statements increases. Alternatively, if an hearer fails to observe these mistakes, which should be corrected before publishing a study, the quality of the statements decreases ( Johnson et al. , 2002 ) .
The competency to place mistakes is determined by the hearer ‘s proficient capablenesss, his cognition of the accounting and audit procedure every bit good as his experience ( DeAngelo, 1981b ) . In add-on, Bonner and Lewis ( 1990 ) suggest that hearer cognition consists of three types of cognition, general sphere cognition, general concern cognition and subspecialty cognition.
The 2nd determiner of audit quality is independency. In malice of the importance of the subject, regulators, practicians and faculty members do non hold on the definition and the operationalization of hearer independency ( Dopuch et al. , 2003 ) For that ground, several bing attacks to auditor independency are discussed following and an appropriate base sing independency is determined to utilize throughout this thesis.
In an early attack to auditor independency, Mautz and Sharaf ( 1961 ) separate existent from evident independency, while Higgins ( 1962 ) relabeled those types to independence ‘in fact ‘ and ‘in visual aspect ‘ , which are normally used presents. The former means that the hearer is really independent from his client, while the latter relates to the hearer ‘s mentality while be aftering and put to deathing an audit ( Dopuch et al. , 2003 )
The US Security Exchange Commission points out that “ an hearer ‘s independency is impaired either when the comptroller is non independent “ in fact ” or when, in visible radiation of all relevant facts and fortunes a sensible investor would reason that the hearer would non be capable of moving without prejudice ” ( SEC, 2000, p.1 ) .
Harmonizing to Bazerman, Morgan and Loewenstein ( 1997 ) , the thought of ‘auditor independency ‘ , explained as organizing an indifferent judgement, is unrealistic. Bias normally enters the encephalon unconsciously and accidentally when doing the judgements itself, non while describing them. Peoples, and therefore hearers, develop a penchant for a certain result and so warrant this by otherwise valuing the importance of several properties of equity. Psychologists call this the self-seeking prejudice ( Bazerman et al. , 1997 ) . It is besides impossible to buttockss, since merely the hearer is cognizant if he is being independent. Furthermore, since some opinions can be made unconsciously, the hearer himself may non even be cognizant ( Bazerman et al. , 2002 ) .
Furthermore, the fiscal dependance on clients creates an anti-independence factor ( Mautz and Sharaf, 1961 ) . The Cohen Commission ( AICPA, 1978 ) supports this averment by reasoning that full independency is practically impossible, since the hearer is hired every bit good as paid by the client.
The footing used throughout this thesis comes from DeAngelo ( 1981a ) . She highlights the hearer ‘s ability to defy several force per unit areas and inducements when an mistake has to be reported as of import sing independency ( DeAngelo, 1981a ) . As the Chair of the AICPA Board of Directors, Robert Medninck, describes: “ Independence is the basis of the accounting profession and one of its most cherished assets ” ( Medninck, 1997, p. 10 ) . Furthermore, The Public Oversight Board ‘s Panel on Audit Effectiveness ( POB, 2000, p. 109 ) provinces that independency is “ cardinal to the dependability of hearer ‘s studies ” .
Over the old ages, a batch of research has been done to look into what factors influence audit quality. Specifically, accounting dirts such as Enron and WorldCom led to renewed concerns sing hearer term of office – which is best described as the relationship between the hearer and the client – and its possible consequence on the quality of an audit ( Johnson et al. , 2002 ) . During these periods it was proposed that compulsory audit-firm rotary motion could be a manner to better the quality of fiscal coverage ( Johnson et al. , 2002 ) which caused a turning involvement in this topic among faculty members and look intoing the consequence of hearer term of office on audit quality became the chief aim of several surveies ( Johnson et al. , 2002 ) . Despite the considerable involvement for the subject, the grounds remains inconclusive and anterior literature has evolved into two opposing positions sing the consequence of hearer term of office on audit quality ( Geiger and Raghunandan, 2002 ) . On the one manus there is literature back uping a positive association between hearer term of office and audit quality ( Carcello and Nagy, 2004 ; Geiger and Raghunandan, 2002 ; Johnson et al. , 2002 ; Myers et al. , 2003 ) , while on the other manus research workers concluded that hearer term of office has a negative influence on the quality of an audit ( Copley and Doucet, 1993 ; Davis et al. , 2000 ; Vanstraelen, 2000 ) . Both point of views are justified by several statements. Advocates of the positive relationship between hearer term of office and audit quality argue that audit costs are lower for long term of office hearers compared to shorter periods of hearer term of office. Second, when audits are repeated, the client and industry cognition of the hearer additions ( Myers et al. , 2003 ) . Supporters of the opposing side, nevertheless, argue that the longer the association between a client and the hearer, the more the involvement of the hearer will be in line with the involvement of the client. This procedure could finally take to diminished hearer independency. There are two of import statements back uping this position. First, they argue that the development of an auditor-client relationship could do independence to gnaw. Second, the relationship leads to an impaired hearer ‘s capacity to consequence critical assessment ( Carey and Simnett, 2006 ) .
As the chief point in this thesis, following two subdivisions elaborate on hearer and CEO term of office and their consequence on audit quality.
2.2 The Effect of Auditor Tenure on Audit Quality
The consequence of hearer term of office on competency is simply based on cognition. As antecedently mentioned, hearer cognition consists of three types, being general sphere cognition, general concern cognition and subspecialty cognition ( Bonner and Lewis, 1990 ) . All are following individually discussed.
188.8.131.52. General Domain Knowledge
First, general sphere cognition is a basic degree of expertness necessary for each hearer. This type of cognition consists of the rudimentss in scrutinizing and accounting, such as the by and large accepted auditing criterions and cognition of the minutess flow in an accounting system. Hearers get this type of cognition by direction, preparation and experience ( Bonner and Lewis, 1990 ) .
184.108.40.206. General Business Knowledge
The 2nd type of hearer cognition is general concern cognition which is best defined as a basic degree of cognition sing the concern of the client house. Examples are understanding of the concern environment and direction inducements. Auditors gain this type of cognition by formal direction and personal experiences ( Bonner and Lewis, 1990 ) .
220.127.116.11. Subspecialty Knowledge
Subspecialty cognition is the concluding type of cognition. It relates to industry-specific and client-specific cognition, which is acquired by developing sing specialised countries or repeated audits within specific industries or with certain clients ( Bonner and Lewis, 1990 ) .
Hearers find themselves in a acquisition curve to derive cognition of the client ‘s industry, the concern it operates in and its associated hazards ( Knapp, 1991 ; PricewaterhouseCoopers, 2002 ) . Consequently, incumbent hearers have accumulated this cognition over clip, seting them in an advantageous comparative place compared to their rivals ( Beck et al. , 1988 ; DeAngelo, 1981a, 1981b ) .
Prior research sing this industry-specific cognition showed that industry groups are related to fiscal statement mistake forms ( Maletta and Wright, 1996 ) and deceitful fiscal coverage ( Beasley et al. , 1999, 2000 ) . A new hearer may non be familiar with industry-specific cognition, which may increase the likeliness of deceitful fiscal coverage ( Carcello and Nagy, 2004 ) . Similarly, research of Ashton ( 1991 ) and Bonner and Lewis ( 1990 ) concluded that industry-specific cognition is positively correlated with the hearer ‘s ability to observe jobs within the fiscal statements. They argue that hearers become familiar with the house and its accounting patterns and hazards over perennial audits and addition cognition by working with multiple houses who operate within the same industry.
Harmonizing to Maletta and Wright ( 1996 ) , the features of mistakes and their sensing methods differ across industries and therefore, hearers who have industry-specific cognition at their disposal are better skilled to place abnormalcies and breaches compared to hearers who do n’t hold such cognition. This statement is consistent with anterior research of Bedard and Biggs ( 1991 ) who found that hearers with cognition of the fabrication industries are better equipped to observe abnormalcies and mistakes in the information of a fabrication client than hearers without such specific expertness in fabrication. Similarly, research of Wright and Wright ( 1997 ) concluded that hearers with important experience in the retail industry are better able to observe mistakes of retail clients.
This subdivision explains how auditor term of office affects the 2nd determiner of audit quality: independency. Auditor term of office can act upon independency in three ways, which now will be individually discussed.
Change of Incentive
The first consequence of hearer term of office on hearer independency relates to switching inducements. Harmonizing to Johnson, Khurana and Reynolds ( 2002 ) hearers make a trade off between the desire to protect the audit house ‘s repute and to avoid judicial proceeding ( Balachandran and Nagarajan, 1987 ; DeJong, 1985 ) and the desire to retain a client and later net income from the battle ( Chow and Rice, 1982 ; Citron and Taffler, 1992 ) .
DeAngelo ( 1981a, 1981b ) argues that incumbent hearers find themselves in a favourable competitory place due to accrued client-specific assets. Additionally, dealing costs are increasing, which means that along with hearer term of office, it gets more expensive for the client to exchange hearers. Such a state of affairs could therefore encourage hearers to be less independent and nonsubjective in order to retain the client ( Johnson et al. , 2002 ) .
Geiger and Raghunandan ( 2002 ) argue that this inducement is expressed in a higher likeliness of ‘low-balling ‘ . This competitory mechanism is a natural response by which the hearer is selling his service at a lower initial fee, in order to obtain the client. The subsequent keeping of the client and the drawn-out auditor-client relationship enhances the likeliness of future net incomes ( Geiger and Raghunandan, 2002 ) . The initial start-up costs incurred in the initial twelvemonth are allocated as sunk costs and should therefore be ignored in the determination procedure. Nevertheless, anterior research documented that start-up costs for audits are non treated as such and do play a important function in decision-making ( e.g. Kleinman and Palmon, 2000 ; Staw, 1976 ; Staw and Ross, 1987 ) . Consequently, hearers may be interested in retaining the freshly acquired audit clients long plenty for the initial start-up costs to be recouped by the watercourse of future hard currency flows ( Geiger and Raghunandan, 2002 ) . Therefore, an hearer ‘s independency and objectiveness could be more badly impaired in the early old ages of the relationship due to the menace of dismissal from the client. Furthermore, hearers may be less likely to publish a going-concern study for houses nearing bankruptcy but alternatively publish an unqualified audit study ( Geiger and Raghunandan, 2002 ) . This point of position is in line with old research by Dye ( 1991 ) . He concluded that low-balling creates an inducement for hearers to positively show the fiscal state of affairs of their client in order to extent the relationship and hence increase the likeliness of future quasi-rents.
In add-on to obtaining the client, hearers besides become more concerned with keeping the client and profiting from the relation, and go less concerned about the judicial proceeding hazard ( Johnson et al. , 2002 ) . This alteration in inducement may diminish an hearer ‘s independency, peculiarly sing of import clients ( Lim and Tan, 2010 ) . These houses are by and large considered an of import beginning of gross, which the audit house may non desire to endanger ( Hoyle, 1978 ) . A long relationship may even take to an economic dependence on the client, which later might cut down independency since the audit house does non desire to put on the line losing the client ( Lee and Gu, 1998 ; Schatzberg and Sevcik, 1994 ) . This is supported by several surveies that have proven that an unfavourable study frequently leads to a switch to another hearer. Harmonizing to Chow and Rice ( 1982 ) the issue of a qualified study is a important ground to engage a different hearer. Schwartz and Menon ( 1985 ) argue that neglecting houses are more likely to alter hearers. Similarly, Williams ( 1988 ) finds that financially hard-pressed houses have a greater inducement to exchange hearers compared to healthy clients in order to retain a good image of the house. Furthermore, Williams ( 1988 ) and Levinthal and Fichman ( 1988 ) both provide grounds that longer hearer term of office is negatively related to auditor dismissal. Jackson, Moldrich and Roebuck ( 2008 ) argue that a director may even endanger to exchange to a new hearer in order to obtain a more favourable study.
In add-on, Carcello and Nagy ( 2004 ) argue that long-standing clients are frequently seen as a ageless rente. An bing client provides the audit house with client-specific gross ( DeAngelo, 1981a, 1981b ) which create an rente of net incomes an hearer expects to have during the audit battle ( Carcello and Nagy, 2004 ) . Sing the client as a beginning of an infinite gross watercourse, might compromise the independency of an hearer ( Carcello and Nagy, 2004 ) . The Commission on Public Trust and Private Enterprise ( 2003 ) see compulsory audit rotary motion as a solution to this possible menace: “ Rotation of hearers would besides cut down any fiscal inducements for external hearers to compromise their judgement on marginal accounting issues. In differing with direction, hearers would no longer be put on the lining a watercourse of grosss that they believed would go on in ‘perpetuity ‘ , since the audit battle would no longer be perceived as lasting ” ( p. 34 ) .
Furthermore, regulators argue that as term of office additions, the fees charged for nonaudit services are acquiring disproportionately big. As these nonaudit fees accumulate, they create inducements to give to client force per unit area ( Stanley and DeZoort, 2007 ) .
A 2nd consequence of long hearer term of office is labeled by the IFAC Code of Ethics ( 2008 ) as the acquaintance menace which is best described as a impairment of the hearer ‘s capacity to consequence critical assessment.
As a consequence of the long audit battle, Shockley ( 1981 ) argues that the audit house develops a “ erudite assurance ” ( p. 789 ) . This assurance in the client is a consequence of the long coaction and reduces the attempt which could attest itself in utilizing less rigorous and originative audit proving attacks. The audit procedure may even go everyday and the hearer starts to expect consequences, such as the province of the accounting systems and the presence of controls, observed from anterior twelvemonth outcomes ( Arrunada and Paz-Ares, 1997 ; Hoyle, 1978 ) . Hence, less clip is devoted to accurately measuring current twelvemonth ‘s statements for possible stuff misstatements ( Arrunada and Paz-Ares, 1997 ; Johnson et al. , 2002 ) .
Similarly, Carcello and Nagy ( 2004 ) argue that, over clip, clients gain a repute inside the accounting house and develop certain outlooks among the audit squad. A house may be known as holding accurate fiscal studies or strong fiscal coverage controls. If the hearers expects these results beforehand, they may go less critical and skeptic ( Carcello and Nagy, 2004 ) . A new audit house could forestall this by supplying a powerful equal reappraisal consequence ( Biggs, 2002 ; POB, 2002 ; Seidman, 2001 ) . This consequence is best described by the fresh position of a new audit house ( Commission on Public Trust and Private Enterprise, 2003 ; Silvers, 2003 ) and its higher degree of objectiveness due to the strangeness with the client ( Jackson et al. , 2008 ) .
Harmonizing to Bazerman, Loewenstein and More ( 2002 ) , a possible for prejudice is created by three facets of accounting. These facets are defined as the ambiguity of construing information, the blessing or rejection of a antecedently made judgement and thirdly the fond regard to the client. Bias is created when an person ‘s desires influence the manner information is interpreted. The single becomes less critical towards information back uping the coveted decision compared to beliing facts. Furthermore, this possible prejudice is intensified by facets which get stronger with term of office. One of those facets is going more familiar with the client as human existences are less likely to harm people they know compared to people they do non cognize ( Bazerman et al. , 2002 ) . This acquaintance refering personal relationships is a important consequence on its ain and hence intricately discussed in the following paragraph.
Erosion of Independence due to the Development of Personal Relationships
Mautz and Sharaf ( 1961 ) argue that long associations with the same client, could hold a damaging consequence on hearer independency since the ability to objectively scrutinize a client reduces over clip. They suggest that an hearer ‘must be cognizant of the assorted force per unit areas, some obvious some subtle, which tend to act upon attitude ‘ . They province that “ the greatest menace to his [ the hearer ‘s ] independency is a slow, gradual, about insouciant eroding of his ‘honest disinterestedness ” ( Mautz and Sharaf, 1961, p. 208 ) . Harmonizing to Dopuch, King and Schwartz ( 2003 ) and Bazerman, Morgan and Loewenstein ( 1997 ) this menace occurs during the coverage period every bit good as the predating period when judgements are made. Hence, the development of bonds, trueness or affectional relationships between an hearer and his client will consciously or subconsciously act upon an hearer ‘s objectiveness and independency and accordingly diminish the ability to accurately scrutinize an entity ‘s fiscal statements ( Carey and Simnett, 2006 ) . Carey and Simnett ( 2006 ) besides explain that the hearer ‘s needed degree of incredulity is reduced as good.
In contrast, consecutive audits accumulate trust ( Arrunada and Paz-Ares, 1997 ) which is helpful since it allows communicating to be at low costs and an equal declaration of struggles. Hence, trust is a important portion of the equal ‘s relationship between the hearer and his client ( Richard, 2006 ) . Yet, as the IFAC codification of Ethical motives provinces: “ a menace occurs when, by virtuousness of a close relationship with an confidence client, its managers, officers or employees, a house or a member of the confidence squad becomes excessively sympathetic to the client ‘s involvement ” ( IFAC, 2008, p. 18 ) . Similarly the Metcalf Committee Report ( U.S. Senate, 1976 ) notes that long association between a client and an audit house may take to such close designation of the audit house with its client ‘s involvements, that it becomes hard to stay genuinely independent.
Furthermore, as hearers might bit by bit place with the client they may even aline with the wants of direction ( Geiger and Raghunandan, 2002 ) and as the length of the audit-client relationship additions, hearers are even more likely to hold with directors on of import coverage determinations ( Farmer et al. , 1987 ; Ryan et al. , 2001 ) . Bamber and Iyer ( 2007 ) support this statement as they found grounds that hearer term of office is associated with higher designation with the client. Their consequences suggest that hearers who identify more with their client are more likely to move in favour of the client, for case when a struggle has to be resolved. Therefore, this client designation has a negative association with hearer objectiveness which in bend supports the concern by the Independence Standards Board ( ISB ) ( 2000 ) sing the menace to hearer ‘s independency from relationships between the client and its hearers.
In add-on, harmonizing to Bazerman, Morgan and Loewenstein ( 1997 ) , the self-seeking prejudice influences the scrutinizing relationship in several ways. First, the hearer is cognizant of the employees within the client house that would be harmed by publishing a negative sentiment on the audit. As people tend to be more concerned about harming known victims, than unknown individuals, this might act upon the determination which study to publish. Second, the negative effects of a negative sentiment could instantly harm the hearer or the audit house. The hearer could lose its friendly relationship with the client and the house might lose the contract with the client and therefore a important beginning of gross. Furthermore, as term of office additions, hearers may bit by bit accommodate to little imperfectnesss of their client ‘s statements and apologize judgements consistent with their ego involvement ( Bazerman et al. , 1997 ) . This reduced independency enhances the likeliness of an hearer giving to client force per unit area in a struggle state of affairs ( McLaren, 1958 ) . Furthermore it could increase hearers ‘ support for more aggressive accounting processs and even ensue in a failure to place material misstatements or fraud ( Myers et al. , 2003 ) and at the utmost consequence in a collusion between the hearer and the client ( McLaren, 1958 ) .
Similarly, several surveies found that larger clients are more likely to convert hearers into utilizing aggressive accounting patterns since they possess greater dickering power ( McKeown et al. , 1991 ; Nelson et al. , 2002 ) .
From a sociological position, Moore, Tetlock, Tanlu and Bazerman ( 2006 ) province that clients bit by bit accumulate force per unit areas to “ promote complacence among practicians ” ( p. 11 ) . This moral seduction even causes an increased likeliness that hearers will “ slant their decisions ” ( Moore et al. , 2006, p. 11 ) .
2.3 The Effect of CEO Tenure on Audit Quality
Compared to auditor term of office, there is much less, if any, anterior research on the impact of CEO term of office on audit quality. The available analyses are chiefly limited to the connexion between the impact of CEO ‘s on net incomes direction and fiscal fraud. The anterior research of involvement for this survey will be explained in this paragraph.
In 1988, Hermalin and Weisbach note that a new CEO has comparatively less power compared to an established CEO. Taking this into history in his survey, Beasley ( 1996 ) did non happen that CEO term of office is related to fiscal statement fraud.
On the other manus, research by Francis, Huang, Rajgopal and Zang ( 2008 ) found that CEO repute, which is among others determined by CEO term of office, acts as a important factor finding net incomes quality ( Francis et al. , 2008 ) .
Core and Guay ( 1999 ) argue that the uncertainness sing a Chief executive officer ‘s ability resolves with the term of office of the CEO, which in bend perchance increases his inducement hazard. For case, directors use option grants in order to personally gain from it ( Aboody and Kasznik, 2000 ; Yermack, 1997 ) . Furthermore Goldman and Slezak ( 2000 ) argue that performance-based wage could take to misreporting public presentation by directors. While analyzing inducements and its relation to fiscal fraud, Erickson, Hanlon and Maydew ( 2003 ) did non happen consistent grounds that executive equity inducements are related to fraud. All in all, based on anterior research it is hard to find the influence of CEO term of office on audit quality.
2.4 Hypothesis Development
Based on the foregoing treatment, it is assumed that the influence of term of office on independency is strongly affected by the personal connexion of an hearer with the client. The designation with the client, the acquaintance with the employees of the client and the development of bonds or affectional relationships, all have a damaging consequence on the hearer ‘s independency. The influence of CEO term of office on its ain nevertheless is ill-defined. When concentrating on the relationship between an hearer and a CEO and its relation to scrutinize quality, there is some anterior research of involvement which will be discussed following.
A recent and yet unpublished survey of Bruynseels and Cardinaels ( 2012 ) found that many audit commission members have societal connexions with their CEO ‘s which causes alleged independent audit commission members non ever to be to the full independent. Particularly in instance of societal ties formed through the friendly relationship web of the CEO, audit commission effectivity is reduced, the audit commission seems to hold lower criterions refering audit attempt and hearers are less likely to describe lacks in internal control or publish going-concern sentiments. Furthermore, audit commissions with friendship ties are far more likely to publish an amendment of a clean internal control study in position of describing a lack ( Bruynseels and Cardinaels, 2012 ) .
In order to understand the existent relationship between an hearer and a client, the organisational and sociological literature addition farther penetration into the affair. The construct of fond regard between professional exchange parties, which is defined as the committedness of one party to another ( Salancik, 1977 ; Staw, 1982 ) , has frequently been addressed in anterior literature. Attachment can be the consequence of ties on both single and organisational degree. Causes of fond regard are for case cognition, personal accomplishments and interpersonal relationships ( Seabright et al. , 1992 ) . Several research workers argued that committedness in a professional relationship creates an inducement for both sides to keep the relationship. Harmonizing to Cook ( 1977 ) , commitment leads to a willingness to go on the relationship in order to work the chances it offers to better their personal places in an exchange web and to increase wagess. Likewise, larning by making develops specific capablenesss for both client and hearer. These relationship-specific accomplishments create an inducement to protract the relationship every bit good ( Levinthal and Fichman, 1988 ) .
In bend, the cognition of a continued relationship leads to a better cooperation of the parties involved ( Heide and Miner, 1990 ) . Hence, Seabright, Levinthal and Fichman ( 1992 ) assume that this reinforced cooperation enhances the auditor-client fond regard. The same applies for the length of the battle of persons in certain exchange activities. Specifically, they argue that fond regard is related to both the length of an interorganizational relationship as the term of office of persons who are in a function of boundary wrench in the relationship. These boundary wrenchs are defined as those persons who have knowledge of possible spouses and whose function requires both inter and intraorganizational relationships ( Van de Ven, 1976 ) . Critical boundary wrenchs in an auditor-client relationship include the main executive officer ( CEO ) , the members of the audit commission, the main fiscal officer ( CFO ) and the main accounting officer ( CAO ) ( Bacon, 1979 ; Macchiaverna, 1981 ; Mautz and Neumann, 1977 ) .
The fond regard that develops over clip adds “ a societal content that carries strong outlooks of trust and abstinence from self-interest ” ( Granovetter, 1985, p. 490 ) . Seabright, Levinthal and Fichman ( 1992 ) conclude that this embeddedness ( Granovetter, 1985 ) is a natural result of the auditor-client relationship, but however causes a divergence from certain outlooks sing the turning away of personal ties to and withdrawal from clients. They farther suggest that a longer relationship between an hearer and a client provides an chance, for the more powerful party, to work the state of affairs. If this were the client, more hazardous and aggressive fiscal coverage determinations might be the consequence. If nevertheless the hearer would be the most powerful, it could take to a decreased attempt of the hearer. In either instance, a higher degree of fond regard may cut down audit quality.
As the CEOs are the most powerful histrions in organisations ( Seabright et al. , 1992 ) , this survey considers the CEOs and the hearers as the chief boundary wrenchs.
Summarized, longer interorganizational relationships between an hearer and a client lead to a higher degree of fond regard, which may in bend cut down audit quality. Taking into history the effects of the acquaintance menace and eroding of independency due to personal relationships described in subdivision 18.104.22.168 and 22.214.171.124 every bit good, the chief hypothesis of this thesis is:
H1: The length of the auditor-client relationship has a negative consequence on audit quality.
This subdivision elaborates on the methodological analysis of this survey. The first paragraph describes and explains the informations aggregation and sample choice. The 2nd portion explains the research method, which is followed by the description and measuring of the variables of involvement and the extra control variables.
Data Collection and Sample Selection
In order to execute the analysis, the first measure is to roll up the necessary informations. For this survey informations is collected from two different databases and later combined. This subdivision elaborates on the procedure of roll uping this information and explains how the concluding sample is built up.
The initial sample, used to gauge working capital accumulations and to find hearer term of office, consists of all firm-years from 1990 to 2010 retrieved from the one-year industrial and research files of Compustat 2012. The usage of publically listed companies is motivated by the separation of ownership and control, which makes independent external audits peculiarly of import for these companies ( Francis, 2004 ) . From the initial sample, fiscal administrations and companies in the public-service corporation sector were eliminated. For the analysis, audit quality is measured in 2010. Hence, all observations from houses being active prior to 2010 but no longer in 2010 itself are non relevant and have hence been deleted. Harmonizing to Myers, Myers and Omer ( 2003 ) the observations of houses who switch hearers in the earlier phases of the relationship perchance differ consistently compared to houses who do non exchange early in the auditor-client relationship. Taking this into history, a minimum auditor-client relationship of five old ages is required ( Myers et al. , 2003 ) . Consequently, all firm-year observations with an auditor-client relationship of less than five old ages were deleted.
In order to find CEO term of office, information is collected from Execucomp. The initial sample from this database consists of all active houses in 2010 retrieved from the one-year files available in 2012.
From this sample, as with the Compustat observations, all observations of executives being CEO prior to 2010 and no longer in the twelvemonth 2010 itself, were eliminated. Therefore, merely each house ‘s current Chief executive officer remained. In some instances houses switched CEO ‘s in 2010. For these companies it is following to impossible to pull decisions about the CEO ‘s influence for the full twelvemonth of 2010. As audit quality is measured in 2010 and CEO term of office is measured in full old ages these observations are non utile and have hence been deleted.
Since both databases have their ain sample choice and because of several riddances made to both samples, both sets of houses of course did non fit. Comparing both sets resulted in a combined set of 1108 alone houses.
Thereafter, all observations from houses with a financial year-end other than the 31st of December were deleted from the sample.
Finally, the observations in the top and bottom one per centum of audit quality, hard currency flow from operations and purchase were deleted to cut down the effects of possible outliers. This leaves the concluding sample with 607 alone houses.
3.2.1. Research Model
This survey closely follows the methodological analysis proposed by Myers, Myers and Omer ( 2003 ) , who analyzed the relationship between hearer term of office and net incomes quality.
As a 2nd measure, the collected information is used to run a multiple arrested development which is “ a statistical method for analyzing the relationship between a individual dependant variable and one or more independent variables ” ( Allison, 1999, p. 1 ) . By utilizing this method, the effects of independent variables can be separated from the dependant variable, here ‘Audit Quality ‘ , in order to find the alone part of each variable ( Allison, 1999 ) .
In order to prove H1 developed in subdivision 2, the undermentioned theoretical account is estimated:
AWCAt = I?0 + I?1AUDCEOTenure + I?2AuditorTenure + I?3CEOTenure + I?4Age + I?5Size + I?6AuditorType + I?7Leverage + Iµ
AWCAt= Abnormal working capital accumulations in 2010.
t= Year 2010.
AUDCEO Tenure = The figure of back-to-back old ages of the coaction of the current CEO and the current hearer.
Auditor Tenure = The figure of back-to-back old ages that the house has retained the hearer.
CEO Tenure = The figure of back-to-back old ages the executive has served as CEO.
Age = The figure of old ages for which entire assets were reported in Compustat since 1980.
Size = The natural logarithm of entire assets.
CFFO = The house ‘s hard currency flows from operations divided by mean entire assets.
Auditor Type = A silent person variable set to 1 if the hearer is a Big Four house and set to 0 otherwise.
Leverage = The ratio of long-run debt to common equity in twelvemonth 2010.
The variables in this equation and their measuring are farther described and explained in the following subdivision.
3.2.2 Variable Measurement
This portion provides a elaborate description of the variables used for this survey. The first paragraph reports a description of the dependant variable audit quality and its measuring. Thereafter, the three explanatory variables auditor term of office, CEO term of office and a combination of these two are presented. The subdivision ends with the description and measuring of the control variables of this survey.
126.96.36.199 Dependent Variable
As audit quality is non discernible, it makes the construct hard to hold on. Despite this trouble, anterior literature has suggested different theoretical accounts to proxy for audit quality. Aggregate accrual theoretical accounts, such as the Jones ‘s theoretical account ( 1991 ) and fluctuations to that theoretical account have widely used to mensurate the quality of accumulations ( Johnson et al, 2002 ; Myers et Al, 2003 ) . However, since working capital accumulations are more likely to be manipulated compared to non-working capital accumulations ( DeFond and Jiambalvo, 1994 ) , this research uses unnatural working accumulations as suggested by DeFond and Park ( 2001 ) as a placeholder for audit quality in 2010. The pick of utilizing working capital accumulations is besides supported by anterior research proposing that directors have the most discretion over these types of accumulations ( Ashbaugh et al. , 2003 ; Becker et al. , 1998 ) . The definition of unnatural working capital accumulations suggested by DeFond and Park ( 2001 ) is accomplished working capital accumulations minus the degree of working capital necessary to back up the current degree of gross revenues ( DeFond and Park, 2001 ) . The historical relationship between working capital and gross revenues consequences in the expected degree of working capital ( DeFond and Park, 2001 ) . Harmonizing to DeFond and Park ( 2001 ) their method is more powerful compared to trials utilizing entire accumulations. The step is expressed into the undermentioned equation:
AWCAt = WCt – [ ( WC ( t-1 ) / S ( t-1 ) ) * St ]
AWCAt = Abnormal working capital accumulations in twelvemonth T.
T = Year 2010.
WCt = Noncash working capital in twelvemonth T, computed as [ ( current assets – hard currency and short term investings ) – ( current liabilities – short term debt ) ] .
St = Gross saless in 2010.
S ( t-1 ) = Gross saless in 2009.
Subsequently, the unnatural on the job capital accumulations of 2010 are deflated by the twelvemonth ‘s entire gross revenues ( Maijoor and Vanstraelen, 2006 ) . In line with anterior literature on audit quality measured by accumulations, tonss are analysed in absolute values ( Carey and Simnett, 2006 ; Johnson et al. , 2002 ; Maijoor and Vanstraelen, 2006 ; Myers et al. , 2003 ) .
188.8.131.52 Explanatory Variable
The explanatory variable of involvement in this survey is AUDCEO Tenure, which is the term of office of hearer and CEO combined. The pick for this variable is motivated by anterior literature and research, discussed in subdivision 2.4. Summarized, the length of the relationship is related to attachment which in clip could develop into embeddedness ( Granovetter, 1985 ) . This embeddedness is a natural result of auditor-client relationships, but causes a divergence signifier professional outlooks, which in bend could do audit quality to worsen ( Seabright et al. , 1992 ) . AUDCEO Tenure is measured as the figure of old ages the hearer and CEO have worked together, as of the twelvemonth 2010.
184.108.40.206 Control Variables
In add-on to the chief variables, some extra variables are included. These variables could perchance impact the dependant variable. Hence, to get the better of these other related effects they are incorporated in the multivariate theoretical account. Consistent with Myers, Myers and Omer ( 2003 ) age, size, hearer type and hard currency flows of operations are being controlled for. Following Johnson, Khurana and Reynolds ( 2002 ) and Maijoor and Vanstraelen ( 2006 ) purchase is besides included as a control variable. In add-on, hearer term of office and CEO term of office are included as control variables.
Age is included since anterior research revealed that accumulations differ when the house ‘s life rhythm alterations ( Anthony and Ramesh, 1992 ; Dechow et al. , 2001 ) . Age is measured as the back-to-back figure of old ages for which Compustat reported entire assets since 1980 ( Myers et al. , 2003 ) . It is expected that age is negatively correlated with unnatural working capital accumulations and hence positively correlated with audit quality.
The 2nd control variable is size. Harmonizing to Dechow and Dichev ( 2002 ) , the quality of accumulations additions with house size due to a greater stableness. A negative correlativity is hence assumed between size and unnatural working capital accumulations. Size is measured as the natural logarithm of entire assets for the twelvemonth ( Carey and Simnett, 2006 ; Myers et al. , 2003 ) .
Evidence of anterior research suggests that large audit houses tend to be more conservative. This leads to an attack that limits utmost accumulations and therefore provides higher audit quality ( Becker et al. , 1998 ; DeFond and Subramanyam, 1998 ; Francis and Krishnan, 1999 ; Francis et al. , 1999 ) . Taking this into history hearer type is included as a 3rd control variable. In line with Myers, Myers and Omer ( 2003 ) , this variable is an index variable, which is set to 1 if the house has a Big Four hearer and 0 otherwise. A positive correlativity is assumed between hearer type and audit quality and therefore a negative correlativity between hearer type and unnatural working capital accumulations is expected in this analysis.
Since there is an reverse relationship between hard currency flow from operations and accumulations ( Dechow, 1994 ; Sloan, 1996 ) , hard currency flow from operations ( CFFO ) is included every bit good. Furthermore, it is more likely that houses with higher operating hard currency flows execute better ( Frankel et al. , 2002 ) . CFFO is measured as hard currency flows from operations scaled by entire assets for house I in the twelvemonth 2010 ( Johnson et al. , 2002 ) . A negative correlativity is expected between hard currency flows from operations and unnatural working capitals.
In add-on, purchase is included as a control variable. Directors of extremely leveraged houses and of companies in fiscal hurt may hold inducements to pull off net incomes in position of debt compact misdemeanors ( DeFond and Jiambalvo, 1994 ) . On the other manus, extremely leveraged houses might be in fiscal hurt. Contractual renegotiations could promote these houses to cut down net incomes which in bend may take to big negative accumulations ( Becker et al. , 1998 ) . Due to these opposite effects, the way of the consequence of this variable is ill-defined. The purchase variable is measured as the ratio of long term debt to common equity for house I in the twelvemonth 2010 ( Maijoor and Vanstraelen, 2006 ) .
Auditor term of office is defined as the length of the relationship in old ages between an audit-firm and its client, as covered by the audited fiscal statements ( Johnson et al. , 2002 ) . Following anterior literature ( Ghosh and Moon, 2005 ; Johnson et al. , 2002 ; Myers et al. , 2003 ) this survey measures auditor term of office as the figure of old ages the client-firm has retained a certain hearer. To find hearer term of office, the Compustat variable ‘Auditor ‘ is used, which assigns a codification to each house twelvemonth. These codifications each represent an audit house. By agencies of this codification the term of office of the hearer is determined for each house. Following Myers, Myers and Omer ( 2003 ) a alteration of hearer due to an audit house merge is considered a continuance of the anterior hearer. Relevant for the sample period of this survey, is the 1998 merge of Coopers & A ; Lybrand ( Compustat hearer codification 3 ) and Price Waterhouse ( Compustat hearer codification 7 ) into PricewaterhouseCoopers ( Compustat hearer codification 7 ) . If houses switched codifications in 1998 from hearer codification 3 to 7, it was seen as a continuance of the hearer. Deserving mentioning as good is the fact that Compustat does non code every individual auditing house but assigns codification 9 for other auditing houses. Since this codification represents several houses instead than one specific audit house, it is impossible to find the length of the auditor-client relationship for these companies. Therefore, observations assigned codification 9 were of no usage and therefore eliminated from the sample.
Finally, CEO term of office is included as a control variable. CEO term of office is defined as the length in old ages the current executive has served as CEO. As antecedently discussed, there is grounds that CEO term of office is non related to fiscal statement fraud ( Beasley, 1996 ) but as a portion of CEO repute does act upon net incomes quality ( Francis et al. , 2008 ) . Due to this small and equivocal grounds, the predicted influence on audit quality is ill-defined.