chi et al - 2011 - the effects of audit partner pre-client and client-specific experience on earnings quality and on perceptions of audit quality

The Effects of Audit Partner Pre-Client and Client-Specific Experience
on Earnings Quality and on Perceptions of Audit Quality



Wuchun Chi
Department of Accounting
National Chengchi University
Taipei, Taiwan
Email:

Linda A. Myers
Department of Accounting
University of Arkansas
Fayetteville, Arkansas 72701
Email:

Thomas C. Omer
Department of Accounting
Texas A&M University
College Station, Texas 77843
Email:

Hong Xie
Von Allmen School of Accountancy
University of Kentucky
Lexington, Kentucky 40506
Email:



November 2011




We thank Brian Bratten, Monika Causholli, Guojin Gong, Ole-Kristian Hope, Yue Li, Linda McDaniel, James
Myers, Robert Ramsay, Steven Salterio, Marjorie Shelley, Shui-Liang Tung, Chung-Fern Wu, Minlei Ye, David
Ziebart, participants at the 2
nd
Symposium of China Journal of Accounting Research, the 2010 CAPANA
Conference, and the 2011 European Accounting Association conference, as well as workshop participants at
National Taiwan University and at the University of Kentucky for helpful comments and suggestions. Wuchun Chi
gratefully acknowledges the financial support from National Science Council (Project No. NSC 94-2416-H-004-
036). Linda Myers gratefully acknowledges financial support from the Garrison/Wilson Chair at the University of
Arkansas. Thomas Omer gratefully acknowledges financial support from Ernst & Young. Hong Xie gratefully
acknowledges financial support from the Von Allmen Research Support endowment and the PWC fellowship
endowment at the University of Kentucky.


The Effects of Audit Partner Pre-Client and Client-Specific Experience
on Earnings Quality and on Perceptions of Audit Quality

SUMMARY: We examine the effects of auditors‘ pre-client and client-specific experience on
earnings quality and on perceptions of audit quality for both public and private companies using
audit data from Taiwan, where the names of signing audit partners are disclosed and both public
and large private companies are required to publish audited financial statements. We use
discretionary accruals to proxy for earnings quality and the bank loan interest rate spread to
proxy for creditor perceptions of audit quality. We find that for public companies, an audit
partner‘s pre-client experience enhances earnings quality, but the effect of pre-client experience
on earnings quality is smaller than that of client-specific experience, suggesting a transition cost
in terms of earnings quality associated with mandatory auditor rotation. For private companies,
we find some evidence that pre-client experience improves earnings quality and that client-
specific experience improves earnings quality, thus extending our understanding of the benefits
of audit partner and audit firm tenure from public to private companies. Finally, we find that
both pre-client experience and client-specific experience improve creditor perceptions of audit
quality for both private and public companies. Our findings are important because they reveal
the effects of more finely parsed measures of auditor experience (tenure) on earnings quality and
on creditor perceptions of audit quality for both public and private companies. Our study is
timely in light of the Public Company Accounting Oversight Board‘s 2011 call for comments on
mandatory auditor rotation. In addition, our findings provides evidence consistent with the
beliefs underlying the Public Company Accounting Oversight Board‘s proposal to disclose the
name of the engagement partner in the audit report – that the disclosure of the engagement audit
partner could provide useful information to investors.


Keywords: Audit partner experience; Auditor rotation; Earnings quality; Audit quality


Data Availability: Data are available from public sources identified in the text.
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INTRODUCTION
The effect of auditor tenure on earnings quality and on perceptions of audit quality has
been the focus of intense debate and research in the recent accounting literature. Prior studies
using U.S. data measure auditor tenure at the audit firm level (e.g., Myers et al. 2003; Mansi et al.
2004) while studies using non-U.S. data measure auditor tenure at the audit partner level (e.g.,
Carey and Simnett 2006; Chen et al. 2008). As such, these studies examine the effects of
auditors‘ client-specific experience, as captured by audit firm tenure and/or audit partner tenure,
on earnings quality and on various measures of the cost of debt (which proxies for creditor
perceptions of audit quality). These studies generally find that longer tenure is associated with
higher earnings quality and with a lower cost of debt (so higher perceived audit quality).
However, an audit partner‘s pre-client experience (the number of years as the signing partner for
other clients prior to the current client) can also play an important role, especially when clients
experience audit firm or audit partner turnover, and whether pre-client experience affects
earnings quality and/or perceptions of audit quality is unexplored in the extant literature.
Studying the effect of pre-client experience is important and timely because of ongoing
arguments for and against audit partner (and audit firm) rotation that center on the potential
detriments associated with longer tenure, as well as the potential benefits from bringing a ―fresh
look‖ to the audit engagement. The issue of mandatory auditor rotation is once again in the
spotlight with the 2011 Public Company Accounting Oversight Board (PCAOB) call for
comments on their concept release proposing mandatory audit firm rotation (Cohn 2011a; Cohn
2011b).
1
A more complete analysis of the issues surrounding mandatory audit firm rotation
should include a consideration of whether the pre-client experience of an incoming audit partner
compensates for the loss of client-specific experience of an outgoing partner. While the benefits

1
Also see ―Accounting board to seek comments on rotating auditors‖ in the New York Times (August 17, 2011).
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and detriments to audit quality from long (audit firm and audit partner) tenure have been tested in
numerous studies in the U.S. and international settings, the benefits of an incoming audit
partner‘s pre-client experience are unexplored.
2
Thus, our focus on the effects of an audit
partner‘s pre-client experience can add to the discussion of the relative costs and benefits of an
incoming partner‘s ―fresh look.‖ Moreover, our examination of an audit partner‘s pre-client and
client-specific experience can also shed light on the potential benefits of recent PCAOB concept
releases that call for disclosure of an audit partner‘s identity in the audit report (PCAOB 2009;
PCAOB 2011).
In this paper, we examine the effects of auditors‘ pre-client and client-specific experience
on earnings quality and on creditor perceptions of audit quality using samples of public and
private companies in Taiwan.
3
Unlike in the U.S., audit reports in Taiwan contain not only the
audit opinion and audit firm name but also the names of the two signing audit partners. In
addition, large private companies were required, like public companies, to file and publish their
audited financial statements before 2002. These distinctive features of the Taiwanese audit
market allow us to develop a more complete set of auditor experience measures than are
examined in prior literature. In particular, we measure the audit partner‘s pre-client experience
for both public and private companies as the cumulative number of years from the first year that
the auditor became a signing partner for any company to the first year that he became a signing
partner for the current client. Our client experience measures allow us to estimate the potential
impact on earnings quality and on perceptions of audit quality of an incumbent audit partner‘s

2
Studies that address audit firm tenure address the potential benefits of a ―fresh look‖ to some extent but do not
consider pre-client experience of the incoming audit partner. Thus, we argue that studying the effects of a ―fresh
look‖ at the audit firm level may be necessary but not sufficient.

3
Public companies are those whose shares are traded on the Taiwan Stock Exchange Corporation or on the GreTai
Securities Market, which are analogous to the New York Stock Exchange and National Association of Securities
Dealers Automated Quotation System, respectively, in the U.S. Private companies are those whose shares are not
listed (publicly traded) on any stock exchange.
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client-specific experience and of a successor audit partner‘s pre-client experience. Results using
our pre-client experience measure suggest that the level of auditor pre-client experience is likely
to be important under a mandatory rotation system.
Our measures of the audit partner‘s client-specific experience differ somewhat between
public and private companies. For public companies, we separate audit partner tenure, and audit
firm tenure, into two periods: (1) the period before the company‘s initial public offering (IPO);
and (2) the period after the IPO. Specifically, we measure the cumulative number of years in
which the audit partner audited the company while it was still private, as well as the cumulative
number of years in which the audit partner audited the company once it had gone public. We
label the former pre-listing audit partner tenure and the latter post-listing audit partner tenure.
We define pre-listing audit firm tenure and post-listing audit firm tenure similarly. Our post-
listing audit partner tenure and post-listing audit firm tenure measures correspond to audit
partner tenure and audit firm tenure in prior studies (e.g., Chen et al. (2008) and Myers et al.
(2003), respectively) but our pre-listing audit partner tenure and pre-listing audit firm tenure
measures are not examined in prior literature. For private companies, we use audit partner tenure
(i.e., the cumulative number of years that the auditor has been a signing partner in the current
client-partner relationship) and audit firm tenure (i.e., the number of consecutive years that the
current client-firm relationship has existed) as our measures of client-specific experience.
We address several research questions in this paper. First, we investigate the effect of
auditors‘ pre-client experience (taking into account the effect of client-specific experience) on
earnings quality and on creditor perceptions of audit quality for public companies. An implicit
assumption underlying mandatory audit partner rotation is that the incoming audit partner‘s lack
of client-specific experience can be alleviated by his pre-client experience so that when this pre-

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client experience is coupled with (presumably) enhanced auditor independence, mandatory
partner rotation enhances earnings quality and perceptions of audit quality. Zerni (2011) finds
that perceptions of higher audit quality associated with individual partners‘ industry
specialization (even after controlling for audit firm industry specialization) influence audit fees
for industry specialist auditors. He suggests that audit partner identity is important to the
market‘s perceptions of ex ante audit quality. However, whether pre-client experience enhances
earnings quality (and is as effective as client-specific experience in enhancing earnings quality)
or affects perceptions of audit quality is unexplored in the extant literature.
4
Our findings can
shed light on these important issues.
Second, we examine the effects of pre-listing audit partner tenure and pre-listing audit
firm tenure on earnings quality and on creditor perceptions of audit quality for public companies.
Here, we examine whether client-specific experience accumulated over the years during which a
public company was still private can benefit the auditor‘s work for that company once it has
gone public. This also allows us to test whether market pressures faced by public companies
affect auditor oversight. The effects of pre-listing experience on earnings quality and on creditor
perceptions of audit quality are also unexplored in the literature.
Finally, we also examine the effects of auditors‘ pre-client experience (taking into
account the effect of client-specific experience) on earnings quality and on creditor perceptions
of audit quality for private companies. Although private companies make up a large portion of
the economy and audit firms do much of their work for private clients (especially those seeking
debt financing), little is known about the financial reporting practices of private companies
(Hope and Langli 2010; Chen et al. 2011) and very little of the extant literature provides

4
The extant literature provides evidence that client-specific experience as captured by audit firm tenure (e.g., Myers
et al. (2003)) or as captured by audit partner tenure (e.g., Chen et al. (2008) and Chi et al. (2011)) is important for

earnings quality. However, it does not consider the effect of pre-client experience.
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evidence about how auditor experience affects earnings quality or creditor perceptions of audit
quality (and hence the cost of debt) for private companies. The exception is Chi et al. (2011). In
concurrent work, Chi et al. (2011) use samples of public and private Taiwanese companies to
investigate whether client importance, measured at the audit partner level, impairs auditor
independence.
5
Although their variable of interest is partner-level client importance, they control
for audit partner tenure but they do not consider the effect of audit firm tenure so the incremental
effect of audit partner tenure cannot be determined. In addition, they do not separately
investigate the effects of pre-client experience and do not study creditor perceptions of audit
quality (cost of debt). Thus, our study contributes to the literature because extant literature has
not examined the effects of pre-client experience and audit partner tenure, after controlling for
audit firm tenure, on the earnings quality of private companies, nor the effects of pre-client and
client-specific experience on creditor perceptions of audit quality for private companies.
Following a long line of research (e.g., Chen et al. 2008; Francis and Yu 2009; Prawitt et
al. 2010; among others), we measure earnings quality using performance-adjusted, modified
Jones model-estimated discretionary accruals. For public companies, we find that pre-client
experience reduces the magnitude (i.e., the absolute value) of discretionary accruals and
constrains extreme negative discretionary accruals (but not extreme positive discretionary
accruals). Regarding client-specific experience, we find that pre-listing partner tenure constrains
the magnitude of discretionary accruals as well as extreme negative discretionary accruals. Pre-
listing audit firm tenure also constrains extreme negative discretionary accruals.
6
Our post-

5
Chi et al. (2011) measure client importance measure as the natural logarithm of client sales divided by the sum of

the natural logarithm of sales for all of the audit partner‘s clients. They proxy for auditor independence using
performance-adjusted discretionary accruals, the auditor‘s propensity to issue modified audit opinions, and the
client‘s probability of meeting or just beating earnings benchmarks.
6
Note that previous studies using samples of public companies find that audit firm tenure constrains both positive
and negative accruals but these studies do not consider pre-listing experience (i.e., they consider only post-listing
experience).
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listing partner tenure and post-listing firm tenure results are consistent with those in Chen et al.
(2008) in that earnings quality tends to increase in both post-listing partner tenure and post-
listing firm tenure. Finally, our tests suggest that the effect of pre-client experience on earnings
quality is smaller than that of client-specific experience. This implies that the loss of the
outgoing partner‘s client-specific experience cannot be fully compensated for by the incoming
partner‘s non-client-specific experience in a mandatory audit partner rotation regime.
For private companies, we find that greater pre-client experience reduces extreme
positive discretionary accruals but does not affect the magnitude of discretionary accruals or
negative discretionary accruals. This finding is somewhat similar to our findings for public
companies in that greater pre-client experience enhances earnings quality but for public
companies we find a constraint on absolute and negative rather than positive accruals. In
addition, we find that for private companies, discretionary accruals become less extreme and that
both negative and positive discretionary accruals are constrained as audit partner tenure increases,
consistent with Chi et al. (2011). We also find that discretionary accruals become less extreme
and positive discretionary accruals are constrained as audit firm tenure increases. Finally,
similar to our findings for public companies, we find that for private companies, the effect of
pre-client experience on earnings quality is smaller than that of client-specific experience so the
loss of the outgoing partner‘s client-specific experience cannot be fully compensated for by the
incoming partner‘s non-client-specific experience.
Similar to Mansi et al. (2004), we use bank loan pricing to proxy for creditor perceptions
of audit quality, and use this proxy for both public and private companies.

7
For public
companies, we find a negative association between pre-client experience and the bank loan

7
Mansi et al. (2004) study the relation between audit firm tenure (equivalent to our post-listing audit firm tenure)
and the cost of debt for public companies in the U.S.
- 7 -

interest rate spread, suggesting greater perceived audit quality with increased pre-client
experience. In addition, the interest rate spread is lower for all of our measures of client-specific
experience—pre-listing audit partner tenure, pre-listing audit firm tenure, post-listing audit
partner tenure, and post-listing audit firm tenure. For private companies, we find that pre-client
experience and client-specific partner tenure lower the interest rate spread. However, we find no
incremental effect of client-specific audit firm tenure on the interest rate spread. Finally, for
both public and private companies, we find that the effect of pre-client experience on creditor
perceptions of audit quality is indistinguishable from that of client-specific experience.
We conjecture that our measures of pre-client experience and client-specific experience
affect creditor perceptions of audit quality for both public and private companies because
creditors in our study (who are primarily Taiwanese banks) likely have greater confidence in
audit partners with more auditing experience, regardless of whether that experience is
accumulated with the current client or with prior clients
Our study contributes to the auditing literature by examining the effects of a more
complete set of auditor experience measures (both pre-client and client-specific) on earnings
quality and on perceptions of audit quality for both public and private companies. Our
examination of these effects for private companies is among the first in the literature. We also
contribute to the auditing literature by separating perceptions of the audit quality associated with
the audit partner versus the audit firm. We document that pre-client experience has an
incremental positive impact on earnings quality and on perceptions of audit quality but its effect
on earnings quality is smaller than the effect of client-specific experience. This implies a net

transition cost associated with mandatory audit partner rotation, although the transition cost is
decreasing in audit partner pre-client experience. Moreover, we document that client-specific
- 8 -

experience accumulated at the audit partner and audit firm levels during the years in which a
public company was still private (i.e., the pre-listing audit partner tenure and pre-listing audit
firm tenure) has an incremental positive impact on earnings quality and on perceived audit
quality, even after controlling for client-specific audit partner tenure and audit firm tenure
following the client‘s IPO.
These findings have a number of implications. First, prior studies suggest that mandatory
partner rotation does not enhance earnings quality (Chi et al. 2009) or is unlikely to enhance
earnings quality (Chen et al. 2008). Our findings imply that using an incoming audit partner
with greater pre-client experience to replace the outgoing audit partner (who has greater client-
specific experience) can partially, albeit not fully, mitigate the detrimental effects on earnings
quality of audit partner rotation. Second, on July 28, 2009, the PCAOB issued a concept release
seeking public comments on its proposal to require that the engagement audit partner sign the
audit report.
8
On October 11, 2011, the PCAOB issued a new proposal for public comment that
would require the engagement partner‘s name be disclosed in the audit report, making the
engagement partner‘s name readily available to audit report users.
9
Underlying the Board‘s
position is a belief that audit partner disclosure identity ―would increase transparency about who
is responsible for performing the audit, which could provide useful information to investors‖
(PCAOB 2009, 5). Our finding that creditors in Taiwan perceive audit quality to be higher when
audit partners with more experience sign financial statements provides evidence consistent with
the Board‘s belief.

8

This is consistent with actions in foreign countries. For example, in 2006, the European Union (EU) issued the
Eighth Company Law Directive, which requires member states, under Article 28, to adopt a mandate requiring the
engagement audit partner to sign the audit report. In addition, proposals requiring mandatory audit firm are
currently being discussed in the EU (see ―EU to propose audit-only firms and mandatory rotation‖ in Accountancy
Age (September 26, 2011)).
9
See ―PCAOB proposes disclosure of engagement partner name‖ in Accounting Today (October 11, 2011) and
PCAOB Proposes Amendments to Improve Transparency through Disclosure of Engagement Partner and Certain
Other Participants in Audits at
- 9 -

Our findings supplement those in Ball and Shivakumar (2005) and Burgstahler et al.
(2006).
10
These papers, among others, find that the financial reporting quality of private
companies is lower than that of public companies presumably due to a lower demand for
financial statement quality for private companies relative to public companies. Our results
suggest that the earnings quality of private companies, as well as that of public companies, is
increasing in auditor experience. Thus, auditor experience can mitigate the financial reporting
quality problems inherent in private companies.
Our findings also supplement those in Kim et al. (2011) and in Minnis (2011). Using a
sample of private Korean companies, Kim et al. (2011) find that the cost of debt capital is lower
for companies with voluntary audits than for companies without voluntary audits (although
whether the audits are performed by Big 4 auditors or by non-Big 4 auditors has no effect on the
cost of debt). Similarly, Minnis (2011) find that the cost of debt is significantly lower for U.S.
private companies whose financial statements are voluntarily audited than U.S. private
companies whose financial statements are not audited. In contrast, we find that for large private
Taiwanese companies whose financial statements were mandatorily audited before 2002, auditor
characteristics such as pre-client experience, client-specific experience, and audit firm size (i.e.,
Big 4 auditors) are negatively associated with the cost of debt.

10
Ball and Shivakumar (2005) argue that although private companies in the United Kingdom (U.K.) are subject to
essentially the same regulatory provisions as U.K. public companies, the market for financial reporting differs
substantially between private and public companies because private companies are less likely to use financial
statements in contracting with lenders and other stakeholders. In addition, their financial reporting is more likely to
be influenced by taxation, dividend policy, and other company policies. These differences imply a lower demand
for financial statement quality (and hence, lower earnings quality) for private companies relative to public
companies. Consistent with this, Ball and Shivakumar (2005) find that U.K. public companies practice more timely
loss recognition than do U.K. private companies. Similarly, using a variety of earnings management metrics
Burgstahler et al. (2006) document that in the European Union, private companies are more likely than public
companies to manage earnings.
- 10 -

In the next section, we review the prior literature and develop our hypotheses. This is
followed by sections that describe our sample selection, and our empirical models and results.
The final section concludes.

LITERATURE REVIEW AND HYPOTHESIS DEVELOPMENT
Numerous studies investigate the relation between audit firm tenure and earnings quality
in the U.S. setting. These studies use discretionary accruals (Johnson et al. 2002; Myers et al.
2003), restatements (Stanley and DeZoort 2007), and fraudulent financial reporting (Carcello and
Nagy 2004) to proxy for earnings quality. Studies investigating the relation between audit firm
tenure and perceptions of audit quality include Mansi et al. (2004), which uses the cost of debt
financing to proxy for creditor perceptions of audit quality, and Ghosh and Moon (2005), which
uses earnings response coefficients to proxy for investor perceptions. We focus on discretionary
accruals because this proxy for earnings quality is available for both private and public
companies in our sample, and we focus on bank loan pricing because this proxy for perceptions
of audit quality is available for both private and public companies in our sample.
The basic argument in these studies revolves around claims made by supporters of

mandatory audit firm rotation—that long auditor tenure leads to complacency over time and, thus,
to a reduction in audit quality and earnings quality, and around counter-arguments made by
opponents of mandatory audit firm rotation—that mandatory rotation imposes costs on the audit
process that result in reduced audit quality and earnings quality in the early years of the audit
engagement.
11
Overall, results of archival studies in the U.S. setting provide no evidence of a

11
Objections to mandatory firm rotation from public accounting firms emphasize the positive role of auditor
experience. For example, in recent letter to the PCAOB, Ernst and Young LLP states, ―Experience with and
knowledge of the personalities and technical abilities of the entity‘s various employees helps inform audit planning
and may prompt increased skepticism in specific areas of the audit (or, in some instances, about certain members of
- 11 -

deterioration of earnings quality with longer audit firm tenure. However, a limitation of these
studies is that they cannot take into account the contemporaneous effect of audit partner tenure
because audit partner identity is not publicly available in the U.S.
Several studies in international settings consider the joint effects of audit firm tenure and
audit partner tenure, or consider the effects of audit partner tenure in isolation. For example,
Carey and Simnett (2006) use Australian data to investigate whether audit partner tenure is
associated with the auditor‘s propensity to issue a going-concern audit opinion to distressed
companies, the direction and amount of abnormal working capital accruals, and the propensity to
just beat earnings benchmarks. They do not find an association between long partner tenure and
abnormal working capital accruals, but they find a lower propensity to issue going-concern
opinions and some evidence that clients are more likely to just beat earnings benchmarks when
partner tenure is long. Overall, their results suggest, at least in the Australian audit market, that
long partner tenure tends to reduce earnings quality. They acknowledge, however, that the
diminution in earnings quality is generally confined to clients of non-Big 5 audit firms.
Prior research using samples of public companies in the Taiwanese setting provides

conflicting results regarding the effects of audit partner tenure and audit firm tenure on
discretionary accruals. In early work, Chi and Huang (2005) find that the association between
both audit partner tenure and audit firm tenure and signed discretionary accruals is negative
when tenure is five years or less, but that it becomes positive when tenure exceeds five years.
However, they do not consider the absolute value of discretionary accruals nor do they examine
positive and negative discretionary accruals separately, which Myers et al. (2003) reveal to be

management)‖ (see
/>CommentLetter_BB2219_FirmRotation_18November2011.pdf).


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important for determining the effect of long tenure. In later work, Chen et al. (2008) use the
absolute value of performance-adjusted discretionary accruals as well as positive and negative
accruals to proxy for earnings quality. They find that absolute and positive discretionary
accruals decrease with partner tenure, and that absolute discretionary accruals decrease with
audit firm tenure (after controlling for audit partner tenure).
As noted previously, an important assumption underlying mandatory audit partner
rotation is that the incoming partner‘s lack of client-specific experience can be alleviated by his
pre-client experience. However, this implicit assumption has not been tested empirically in the
extant literature because although prior studies investigate the effects of audit partner tenure and
audit firm tenure (i.e., client-specific experience), they do not address the effects of audit partner
pre-client experience. Given prior findings that the signing partner‘s lack of client-specific
experience adversely affects earnings quality (Chen et al. 2008), it is important to investigate the
extent to which the signing partner‘s pre-client experience impacts earnings quality and
perceptions of audit quality.
We suggest that signing partner pre-client experience likely impacts earnings quality
because auditor experience can improve error or misstatement detection (Tubbs 1992;
Hammersley 2006) and can reduce auditor reliance on management‘s favorable assessments

(Kaplan et al. 2008).
12
Specifically, Tubbs (1992) investigates how experience changes auditors‘
knowledge of errors and irregularities. He finds that more experienced auditors recognize more
atypical errors and recall more errors, and suggests that this should improve audit quality; we
suggest that it should also improve earnings quality. Similarly, Hammersley (2006) finds that

12
Note that one argument advanced as supporting audit partner rotation is that the new auditor is less likely to
concede to management pressure for reporting specific financial outcomes and because he brings ‗a fresh set of eyes‘
to the table, and thus is more likely to detect errors than are audit partners who may have become complacent
because of their long tenure.
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industry experience allows auditors to develop better knowledge structures which allow them to
identify misstatements for companies in their industry and to specify the appropriate audit
response even when they receive only partial information about a misstatement. Kaplan et al.
(2008) test whether experience limits auditor reliance on management-provided information
when that information is more favorable than an objective benchmark. They find that as auditors
gain experience, they are more able to deflect management‘s persuasion attempts. In addition,
we posit that the experience effects noted above also impact perceptions of the audit quality, and
thus, engagement partners with more experience are likely to be perceived as providing higher
quality audits.
Theoretical and empirical research in a variety of disciplines similarly demonstrates the
positive effect of experience on performance. Learning-by-doing theory suggests that increased
experience reduces the cost of performing a task, resulting in improved performance (Arrow
1962; Anzai and Simon 1979). Empirical studies find that more experienced individuals place
greater weight on relevant cues (Brucks 1985), have more highly developed cognitive structures
(Chi et al. 1981), and search for more information, while focusing on more relevant and more
important information (Chiesi et al. 1979).

Shelton (1999) and Trotman et al. (2005) are also relevant to our hypotheses. Shelton
(1999) finds that experience reduces the impact that irrelevant information can have on audit
judgments, suggesting that signing partners with greater pre-client experience may be better able
to focus on relevant information. Moreover, Trotman et al. (2005) find that engaging in mock
negotiations about financial reporting issues prior to client negotiations improves auditor
negotiation performance, suggesting that signing partner pre-client experience should improve
- 14 -

auditor performance in negotiations with clients, and we suggest that this should improve audit
quality.
13

In addition, Bonner and Walker (1994) suggest that performance improves only when
experience is coupled with feedback. Auditors receive feedback on the quality of accruals when
future cash flows are realized and whenever prior financial statements are found to be misstated.
Thus, pre-client experience should improve auditors‘ performance on general auditing tasks.
However, whether the effect of pre-client experience is equivalent to that of client-specific
experience is an empirical issue.
Mansi et al. (2004) study the effect of audit quality on the cost of debt and find that the
costs of debt financing are lower for clients of Big N audit firms and for companies with longer
auditor-client relationships. This suggests that creditors perceive audit quality to increase in
audit firm tenure. However, the results in Mansi et al. (2004) cannot speak to the relation
between individual audit partner experience (either pre-client experience or client-specific
experience) and perceptions of audit quality (and so the cost of debt) because of data limitations
in the U.S. setting. We posit that a signing partner with substantial pre-client experience and/or
client-specific experience is more likely to be known to creditors in the Taiwanese market, and
that, all else equal, an audit partner with more experience will be perceived as a providing higher
audit quality.
To summarize, we investigate the effects of auditors‘ pre-client and client-specific
experience on earnings quality and on perceptions of audit quality for both public and private

companies in Taiwan. Our hypotheses, stated in the alternative, are as follows:

13
Interestingly, the PCAOB also acknowledges the importance of auditor experience and lists ‗ineffective reviews
because the concurring partner lacked expertise and experience‘ as one of the most serious and common problems
found during its first three years of inspections (see ―The 11 Things Auditors Need to Fix‖ in CFO.com (October 23,
2007)).
- 15 -

H1: Earnings quality is increasing in auditors‘ pre-client and client-specific experience
for public or private companies.

H2: Creditor perceptions of audit quality are increasing in auditors‘ pre-client and client-
specific experience for public or private companies.


SAMPLE SELECTION
Taiwanese Company Law and the Taiwan Securities and Exchange Act divide limited
liability companies into two categories: (1) those that are required to file audited financial
statements with the regulatory authority and make these statements available to the general
public; and (2) those that are not required to file or publish audited financial statements.
Beginning in 1980, the laws in Taiwan required all publicly listed companies (i.e., companies
whose stocks are traded publicly on a Taiwanese stock exchange) and privately-held companies
whose capital level exceeds a certain threshold to file and publish audited financial statements.
The threshold was 200,000,000 New Taiwan Dollars (TWD) until 2000 but it was increased to
500,000,000 TWD in 2000 in response to critics‘ concerns that the benefit of requiring large
private companies to file and publish audited financial statements may not exceed the cost of
compliance. However, concerns remained, and on November 12, 2001, the requirement that
large private companies file and publish audited financial statements was rescinded. Although
some large private companies continued to publish audited financial statements after 2001, an

increasing number chose to cease publication over time. Note, however, that publicly listed
companies have been required to file and publish audited financial statements throughout our
sample period.
In Taiwan, public companies and large private companies are subject to identical
financial reporting requirements and auditing standards. The Taiwan Economic Journal (TEJ)
- 16 -

collects financial statement data for both public and large private companies, and also collects
stock market data for public companies. A company is included in TEJ‘s public company
database for the years during which it is listed on a Taiwanese stock exchange and is included in
the TEJ‘s private company database for the years during which it is not traded on a Taiwanese
stock exchange. If a company changes its type in a year (e.g., from private to public), the TEJ
includes that company‘s public years in the public company database and its private years in the
private company database (i.e., it does not retroactively reclassify the company‘s prior years
according to its latest type).
We collect data for 1990 through 2001 from the 2008 TEJ annual database. Our sample
period starts in 1990, following Chen et al. (2008), because companies were initially required to
prepare statements of cash flow in that year and we use the statement of cash flow approach to
calculate total accruals (Hribar and Collins 2002). Our sample period ends in 2001 because large
private companies were no longer required to file and publish audited financial statements after
2001 and because the formal announcement of a new mandatory partner rotation requirement
was made in April 2003, thus affecting audited financial statements (which are not due until four
months after the end of the fiscal year in Taiwan) for 2002. Ending the public companies sample
period in 2001 allows us to avoid any potential effects of the adoption of mandatory audit partner
rotation on accruals.
We initially obtain 5,797 (22,225) company-year observations from 2008 TEJ‘s public
(private) company database. Consistent with prior studies, we delete 419 (636) observations in
the financial services industry. In addition, we eliminate 174 (9,492) observations because of
missing beginning-of-the-year total assets, cash from operations, growth, and tenure measures
for our public (private) companies. We also delete 67 (1,606) observations in industries with less

- 17 -

than 8 observations available for calculating discretionary accruals. Finally, we delete 718
public company observations in the year of an initial public offering (IPO) because Teoh et al.
(1998a) and Teoh et al. (1998b) find that earnings management patterns differ for IPO firms.
14

This provides us with 4,419 (10,491) public (private) company-year observations in our
discretionary accruals sample. We use this sample to examine the effects of pre-client
experience and client-specific experience on earnings quality. In the next section, we describe
how we derive our bank loan pricing sample from this discretionary accruals sample, and we use
the bank loan pricing sample to examine the effects of pre-client experience and client-specific
experience on creditor perceptions of audit quality.

EMPIRICAL MODELS AND RESULTS
In this section, we examine the effects of auditors‘ pre-client and client-specific
experience on earnings quality and on perceptions of audit quality for public and private
companies, respectively. We first present our empirical models and results using abnormal
accruals to proxy for earnings quality. We then present our empirical models and results using
bank loan pricing to proxy for creditor perceptions of audit quality.
Accrual-based Proxies for Earnings Quality
Variable Measurement and Empirical Model
Prior literature uses various measures of accruals to proxy for earnings quality. We
follow prior literature and calculate performance-adjusted discretionary accruals using the
following modified Jones (1991) model:
15

TAC
t
= 

t
(1/TA
t1
) + 
t
(SALES
t
– AR
t
) + 
t
PPE
t
+ 
t
ROA
t1
+ 
t
(1)

14
Untabulated tests reveal that our results are robust to their inclusion.
15
We omit company subscript i for brevity.
- 18 -

where:
TAC
t

=
total accruals in year t, calculated using the statement of cash flow approach
recommended by Hribar and Collins (2002) as income before discontinued
operations and extraordinary items – (cash from operations – discontinued
operations and extraordinary items from the statement of cash flows);
TA
t1

=
total assets at the end of year t-1;
SALES
t

=
the change in sales revenue between year t and year t-1;
AR
t

=
the change in accounts receivable between year t and year t-1;
PPE
t

=
the gross amount of property, plant and equipment at the end of year t; and
ROA
t1

=

return on assets in year t-1, calculated as the ratio of income before
discontinued operations and extraordinary items to total assets.

TAC
t
, SALES
t
, AR
t
, and PPE
t
are scaled by lagged total assets (TA
t1
). We estimate equation
(1) in the cross section in each year (i.e., from 1990 through 2001) for each TEJ industry
classification with at least eight available observations. The residuals from equation (1) are our
performance-adjusted discretionary accruals (PADJDA
t
).
Beginning in 1983, audit reports for both public and large private companies in Taiwan
were required to be signed by two audit partners. The names of the audit firm and of the two
signing partners are disclosed in the audit reports. However, the audit report does not indicate
which partner is the lead (or review) partner. Following Chen et al. (2008), we assume that the
audit partner whose client-specific tenure is longer has more influence on the audit work, and
thus measure partner-related experience variables based on this audit partner.
For each observation in our public companies sample, we separate audit partner tenure
and audit firm tenure into two parts: the portion during which the company was private and the
portion during which the company was public. Specifically, we measure the cumulative number
of years during which the partner audited the current public company from 1983 or the year of its
establishment, whichever is later, to the IPO year and label this pre-listing audit partner tenure

(PreListPT). We then measure the cumulative number of years during which the partner audited
the current public company from the IPO year to the current year and label this post-listing audit
- 19 -

partner tenure (PostListPT). Thus, the total number of years during which the partner audited the
current public company is the sum of PreListPT and PostListPT. Similarly, we measure the
consecutive number of years during which the audit firm audited the current public company
from 1983 or the year of its establishment, whichever is later, to the IPO year and label this pre-
listing audit firm tenure (PreListFT). We then measure the consecutive number of years during
which the audit firm audited the current public company from the IPO year to the current year
and label this post-listing audit firm tenure (PostListFT).
16
Thus, the total number of years
during which the audit firm audited the current public company is the sum of PreListFT and
PostListFT.
To measure pre-client experience for our public companies sample, we trace the audit
partner back to 1983 to identify the first year in which this partner became a signing partner for
any company (public or private). We define partner total experience (TotExp) as the cumulative
number of years from this partner‘s first year as a signing partner to the current year. We also
identify the first year in which this partner was a signing partner for the current company and
define pre-client experience (PreClientExp) as the cumulative number of years from this
partner‘s first year as signing partner for any company to his first year as signing partner for the
current company (so PreClientExp = TotExp – (PreListPT + PostListPT)).
For each observation in our private companies sample, we measure the cumulative
number of years during which the partner has been a signing partner for the current company
(since 1983 or the year of the company‘s establishment, whichever is later), and define this as
audit partner tenure (PT). We also measure the number of consecutive years that the audit firm
has been auditing the current company and define this as audit firm tenure (FT). Finally, we

16

TEJ calculates and provides PreListPT, PostListPT, PreListFT, and PostListFT. TEJ calculates audit partner
tenure using the cumulative number of years but audit firm tenure using the consecutive number of years.
- 20 -

define partner total experience (TotExp) and partner pre-client experience (PreClientExp) in the
same way as for public companies (so PreClientExp = TotExp – PT).
Our measure of client-specific experience differs slightly between public and private
companies. For public companies, we use pre-listing audit partner tenure (PreListPT), post-
listing audit partner tenure (PostListPT), pre-listing audit firm tenure (PreListFT), and post-
listing audit firm tenure (PostListFT) to measure client-specific experience gained prior to and
after the IPO year but for private companies, we use audit partner tenure (PT) and audit firm
tenure (FT) to measure client-specific experience. In contrast, our measure of pre-client
experience (PreClientExp) is the same for both public and private companies.
We note several differences between our measures of auditor experience and those used
in prior studies. First, pre-client experience is unexplored in the extant literature for both public
and private companies. Second, Chen et al. (2008) and Myers et al. (2003) measure audit partner
tenure and audit firm tenure for public companies using only the years during which their sample
companies were public, and so their measures correspond to our PostListPT and PostListFT.
Prior research has not examined the effects of PreListPT and PreListFT on earnings quality or on
perceptions of audit quality. Finally, as described previously, Chi et al. (2011) control for audit
partner tenure when examining the relation between auditor independence and client importance.
Their partner tenure variable corresponds to the sum of PreListPT and PostListPT for public
companies and to PT for private companies. They do not, however, control for audit firm tenure
or examine the effect of pre-client experience on earnings quality or the effect of pre-client and
client-specific experience on perceptions of audit quality.
- 21 -

In order to examine the effects of pre-client and client-specific experience on earnings
quality for public and private companies, respectively, we adapt the model in Chen et al. (2008)
and use the following models for our analyses.

For public companies:

PADJDA
=

0
+ 
1
PreClient
2

3

4
PostListPT

5

6

7
Growth 
8

9

10
Age
 +  +  (2)

For private companies:
PADJDA
=

0
+ 
1
Pre-ClientExp 
2

3
FT 
4
Size 
5

6
CFO

7

8
Age +  +  +  (3)

where:
PADJDA
=
performance-adjusted, modified Jones model-estimated discretionary
accruals, measured in absolute, positive, and negative values in year t;
TotExp

=
the audit partner‘s total experience for both private and public
companies = the cumulative number of years from the first year in
which the partner became a signing partner for any company to the
current year (t);
PreClientExp
=
pre-client audit partner experience = the cumulative number of years
from the partner‘s first year as signing partner for any company to his
first year as signing partner for the current company. For public
companies, PreClientExp = TotExp – (PreListPT + PostListPT). For
private companies, PreClientExp = TotExp – PT.

PreListPT
=
pre-listing audit partner tenure for public companies = the cumulative
number of years (since 1983 or the year of the company‘s establishment,
whichever is later) during which the partner audited the current company
while it was private, to the IPO year;
PostListPT
=
post-listing audit partner tenure for public companies = the cumulative
number of years during which the partner audited the current company
from its IPO year to the current year (t);
PT
=
audit partner tenure for private companies = the cumulative number of
years (since 1983 or the year of the company‘s establishment, whichever
is later) during which the audit partner audited the current private
company, to the current year (t);

PreListFT
=
pre-listing audit firm tenure for public companies = the number of
consecutive years (since 1983 or the year of the company‘s
establishment, whichever is later) during which the audit firm audited
the company while it was private, to the IPO year;
- 22 -

PostListFT
=
post-listing audit firm tenure for public companies = the number of
consecutive years during which the audit firm audited the current
company from its IPO year to the current year (t);
FT
=
audit firm tenure for private companies = the number of consecutive
years (since 1983 or the year of the company‘s establishment, whichever
is later) during which the audit firm has audited the current private
company, to the current year (t);
Size
=
the natural logarithm of total assets in year t;
Growth
=
growth rate of net sales over the previous year;
CFO
=
cash from operations from the statement of cash flows in year t, scaled
by total assets at the beginning of year t;
BigN

=
an indicator variable equal to 1 if the auditor is from a Big 4 (or 5 or 6)
audit firm, and 0 otherwise;
Age
=
the number of years since the company was established;
Year
=
year indicators; and
Industry
=
industry indicators.



We follow Chen et al. (2008) and include several control variables in equations (2) and
(3). Because prior research finds that the accruals of larger companies tend to be less extreme
(Dechow and Dichev 2002), we include Size.
17
We also include Growth to control for the effect
of growth in net sales on a company‘s accruals, CFO to control for the negative relation between
accruals and cash from operations (Dechow 1994), BigN to control for the potential effect of
audit firm size on earnings quality (Becker et al. 1998), and Age to control for changes in
accruals over a company‘s life cycle (Anthony and Ramesh 1992). Finally, we control for
potential year and industry effects.
Empirical Results
Table 1 reports descriptive statistics for the public and private discretionary accruals
samples. The mean and median performance-adjusted discretionary accruals (PADJDA) for
public companies are -0.0017 and -0.0060, respectively, whereas those for private companies are
0.0044 and -0.0060. The mean and median |PADJDA| are 0.0751 and 0.0494 for public

17
Because large companies face higher political costs (Watts and Zimmerman 1986), they may be less likely to
manage earnings. Consistent with this, Dechow and Dichev (2002) find that large companies tend to report larger
but more stable accruals.
- 23 -

companies, and 0.1059 and 0.0699 for private companies. The mean and median |PADJDA| for
private companies are significantly larger than their public company counterparts (test statistics
are untabulated). This suggests that earnings quality of private companies is, on average, lower
than that of public companies, consistent with Ball and Shivakumar (2005) and Burgstahler et al.
(2006). The mean partner total experience (TotExp) for public companies (11.8192 years) is
longer than that for private companies (10.5286) but the mean audit partner pre-client experience
(PreClientExp) is shorter for public companies (3.9835 years versus 6.5155 years). The mean
combined pre- and post-listing partner tenure (PreListPT + PostListPT) for public companies is
7.8357 years, which is longer than the mean audit partner tenure (PT) for private companies
(4.0132 years). The mean combined pre- and post-listing audit firm tenure (PreListFT +
PostListFT) for public companies is 7.9991 years, which is also longer than the mean audit firm
tenure (FT) for private companies (3.9534 years). Finally, the mean Size, CFO, BigN, and Age
for public companies are all larger than their respective private company counterparts, but the
mean Growth is smaller for public companies than for private companies.
[Insert Table 1 here]
We examine the effects of pre-client and client-specific experience on earnings quality
for public companies using equation (2). We first estimate equation (2) for the full public
companies sample; here, the dependent variable is the absolute value of accruals (|PADJDA|).
We use ordinary least squares regression and following Gow et al. (2010), we report test
statistics using two-way cluster-robust standard errors (i.e., clustering by company and by year)
to adjust for both cross-sectional and time-series dependence in our panel data. We then estimate
equation (2) for positive and negative accruals subsamples; here, the dependent variable is