bamber and bamber - 2009 - discussion of mandatory audit partner rotation, audit quality, and market perception - evidence from taiwan [mapr]

Contemporary Accounting Research

Vol. 26 No. 2 (Summer 2009) pp. 393–402 © CAAA
doi:10.1506/car.26.2.3

Discussion of “Mandatory Audit Partner Rotation,
Audit Quality, and Market Perception:
Evidence from Taiwan”*

E. MICHAEL BAMBER,

University of Georgia

LINDA SMITH BAMBER,

University of Georgia

1. Introduction

Chi, Huang, Liao, and Xie (2009) examine the effect of mandatory audit partner
rotation on audit quality and the market’s perception of audit quality, measured
using abnormal accruals and earnings response coefficients (ERCs). The effect of
audit partner rotation on audit quality is an important question. Audit partner rota-
tion is costly for auditing firms, especially with the increased frequency of rotation
mandated by the Sarbanes-Oxley Act. Moreover, as DeFond and Francis (2005,
26) note, “there is a greater need than ever for objective scientific evidence to guide
public policy-making in auditing now that it is explicitly controlled by a govern-
ment agency [the Public Company Accounting Oversight Board] rather than the
active product of competitive market forces”.
To date, there has been little empirical evidence on the costs or benefits of

audit

partner

rotation because of lack of data; in North America, engagement
partners are not publicly identified. Chi et al. (2009) capitalize on the fact that in
Taiwan, audit partners are identified in audit reports, and the two leading Taiwan-
ese stock exchanges effectively mandated audit partner rotation in 2004. The Tai-
wan experience provides a unique opportunity to examine the effects of mandatory
audit partner rotation. The authors compare clients required to change their audit
partners in 2004 with (a) clients not yet subject to mandatory rotation, (b) clients in
the mandatory rotation sample, but measured in the year before mandatory rotation,
and (c) clients in prior years whose audit partners rotated voluntarily.
Regulators and even associations of professional auditors believe that audit
partner rotation enhances audit quality.

1

Regulators are requiring auditor rotation
out of concern that long tenure may erode auditor independence and/or hinder the
auditor’s ability to develop creative and innovative audit programs due to compla-
cency or overfamiliarity (Carey and Simnett 2006). The idea is that a fresh perspective

* Accepted by Michael Willenborg. An earlier version of this paper was presented at the 2005

Con-
temporary Accounting Research

Conference, generously supported by the

Canadian Institute of
Chartered Accountants

, the

Certified General Accountants of Ontario

, the

Certified Man-
agement Accountants of Ontario

, and the

Institute of Chartered Accountants of Ontario

. We
thank Michael Willenborg (associate editor) for giving us the opportunity to discuss this paper.
We have benefited from helpful comments by Orie Barron, Jeremy Griffin, and Isabel Yanyan
Wang.

394 Contemporary Accounting Research

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Vol. 26 No. 2 (Summer 2009)

will lead to higher-quality audits. As Chi et al. (2009) recognize, however, auditor
rotation has costs as well as benefits. Given the loss of client-specific knowledge
that potentially impairs the effectiveness and quality of the audit, there is a real

need for scientific evidence on the extent to which rotation yields the benefits regu-
lators anticipate. Researchers have responded by producing a flurry of studies on
the association between auditor rotation (or nonrotation in the form of auditor ten-
ure) and various measures of audit quality. As explained in the next section, Chi et al.
(2009) contribute to this research stream.
In this discussion, we focus on four main points concerning the Chi et al. 2009
study and where we see the greatest potential for future research on audit partner
rotation and audit quality. First, we discuss how Chi et al. fit into the context of the
extant literature, and we compare the challenges arising in tests of

audit partner

rotation versus

audit firm

rotation. Second, we consider the research design in Chi
et al. 2009. As they suggest, the Taiwanese data provide an opportunity to address a
research question that cannot be similarly addressed in a North American context.
But the data and research design carry their own set of problems, including issues
of statistical power. Third, we consider Chi et al.’s measures of audit quality. Inter-
preting their study as providing evidence on audit quality assumes not only that
audit quality and earnings quality are interchangeable, but also that abnormal
accruals and ERCs are good measures of earnings quality and, by extension, audit
quality. While such arguments are common in the archival audit literature, we
believe it is time to move beyond these generic proxies, especially if we want regu-
lators to act on our research in settings as specific as audit partner rotation. Finally,
our discussion concludes with suggestions for future research.

2. Size matters: Effects of rotating audit firms versus audit partners

Auditor rotation can be accomplished by changing either the audit firm or the audit
partner. Most of the evidence on the effects of auditor rotation on audit quality is
based on audit firm rotation, although to date regulators have yet to require audit
firm rotation. Instead, regulators in the United States, United Kingdom, Taiwan,
Australia, and many other countries around the globe effectively require audit part-
ner rotation.
Because audit firm rotation is not mandatory, extant research explores the
effect of voluntary audit firm (non)rotation, by documenting the relation between
audit firm tenure and measures of audit quality. The general result from this litera-
ture is that longer audit firm tenure is associated with higher-quality financial
reporting. For example, Johnson, Khurana, and Reynolds (2002) and Myers,
Myers, and Omer (2003) conclude that longer audit firm tenure constrains extreme
absolute abnormal accruals. Mansi, Maxwell, and Miller (2004) find that longer
audit firm tenure is associated with higher bond ratings and a lower cost of debt,
and Ghosh and Moon (2005) find that longer audit firm tenure is associated with
greater value-relevance of reported earnings and higher Standard & Poors’ ratings
of the client’s shares. Using a field-based analysis, Bamber and Iyer (2007) find
longer audit firm tenure mitigates acquiescence to the client’s preferences.

2

These
results are consistent with critics’ arguments that the costs of audit firm rotation (in

Discussion of “Mandatory Audit Partner Rotation and Audit Quality” 395

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terms of lost client-specific knowledge) exceed the benefits, thereby impairing
rather than improving audit quality.
We cannot extrapolate effects of audit firm rotation to audit partner rotation
because the costs and benefits are likely quite different. In audit firm rotation, the
new firm brings a new audit team, applies the (new) firm’s own audit methodology,
and also applies additional new client procedures. In audit partner rotation, in most
cases all that changes is one audit partner. What does not change is the audit firm
and its audit methodology, prior working papers, and the firm’s history with the cli-
ent, the rest of the audit team, and, in most cases, one of the two audit partners.
Furthermore, Chen, Lin, and Lin (2008) note that mandatory partner rotation in
Taiwan can be superficial in the sense that the partner rotates off a client only to
rotate back on the following year, and maintains a relationship with the client over
the entire period. Chen et al. (2008) report that over half the partners who rotated
off in 2003 or 2004 rotated back onto the client after one year. Such superficial
audit partner rotation is unlikely to have any effect on audit quality.

3

Given that changes resulting from audit partner rotation are much more limited
in scope than changes from audit firm rotation, the costs and benefits are likewise
more limited. Audit partner rotation can improve independence if problems arise
from the individual partner and the new engagement partner significantly influences
the rest of the audit team, but partner rotation cannot solve independence problems
arising from audit firm culture. Audit partner rotation is less likely to compromise
audit team competence because other elements of the audit team and technology
remain in place, and legal liability increases incentives for the outgoing partner and
the national office to train and monitor the incoming partner. Consequently, audit
partner rotation is likely to yield effects that are second-order relative to effects of
audit firm rotation. As researchers try to identify increasingly subtle economic

effects, increasing the power of the empirical tests becomes more important.
Chi et al. (2009) add to the emerging literature on the effects of audit partner
rotation. This literature is more limited than the audit firm rotation literature
because of limited availability of data on the identity of lead audit partners running
specific engagements. Australia and Taiwan are exceptions where the lead part-
ner(s) can be identified. On the basis of an analysis of a sample of clients in 1995
before audit partner rotation became mandatory in Australia, Carey and Simnett
(2006) conclude that audit quality suffers when the audit partner’s tenure exceeds
seven years. Specifically, when the partner’s tenure exceeds seven years, finan-
cially distressed clients are less likely to receive a going-concern qualification, and
there is also some evidence that the client is less likely to report earnings that just
miss breakeven. (They also conclude that this deterioration in audit quality is
attributable to non–Big 6 auditors.) However, Carey and Simnett (2006) find no
evidence that signed or absolute abnormal accruals are associated with audit partner
tenure. In contrast, Chen et al. (2008) conclude that audit quality improves with
audit partner tenure. In the 1990 – 2001 period, before audit partner rotation
became mandatory in Taiwan, Chen et al. (2008) conclude that both absolute
performance-matched abnormal accruals and income-increasing performance-
matched abnormal accruals decrease with audit partner tenure.

4

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Chi et al. (2009) contribute by examining the effect of

mandatory

audit partner
rotation in Taiwan. They conclude that mandatory partner rotation does not
improve audit quality and may, in fact, impair audit quality relative to the same
client firm in the year before mandatory rotation. Specifically, they find that abso-
lute and income-increasing performance-matched abnormal accruals are larger for
clients experiencing mandatory partner rotation than for the same clients in the
year before the mandatory rotation. It is comforting that this inference is similar to
the evidence in Chen et al. 2008, which is also based on data from Taiwan, albeit
during an earlier period, when partner rotation was voluntary rather than manda-
tory. However, Chi et al. find no difference between mandatory rotation clients’
abnormal accruals and those of (a) other clients not subject to mandatory rotation
or (b) clients whose audit partners rotated voluntarily (before rotation was
required). Also, they find that the ERC is higher for mandatory rotation clients than
the voluntary rotation benchmark group, but there is no difference between the
mandatory rotation group and the other two benchmark groups.

3. Research design and statistical power

Chi et al. (2009) is almost a “no-results” paper. This does not mean the paper
should not be published. Greenwald (1975) explains that the well-documented edi-
torial bias against publishing papers that fail to reject the null hypothesis delays the
acquisition of knowledge by fostering the publication of studies whose results are
true, but of limited generalizability. We would add that unwillingness to publish
“no-results” papers impedes science in two additional ways: (a) by obfuscating
research initiatives that yield unexpected results, thereby failing to prevent other
researchers from going down the same less-than-fruitful path; and (b) by giving
researchers dysfunctional incentives to torture the data until those data confess
something (anything!) with a

p-

value of 0.05 or better. Lindsay (1994) provides
evidence that editorial “bias against the null” occurs in the accounting discipline.
Bamber, Christensen, and Gaver (2000, 124) further argue that in combination
with the bias against publishing replications (which is more extreme in the field of
accounting than in hard sciences, where replication is the norm), editorial bias
against the null “can lead to a situation where the first published studies are more
likely to reject the null, and these initial studies have a disproportionate effect on
subsequent research due to the bias against publishing replications”. For these rea-
sons, we argue that it is vitally important to publish “no-results” studies.
That said, it is equally important for researchers to make the case that the
study’s empirical tests are powerful enough to detect an economically material
effect, should one exist. Above, we have explained why any effect of audit partner
rotation is likely to be modest. Detecting an effect of modest size requires powerful
tests. Two inescapable features of the Chi et al. 2009 setting likely reduce the
power of the study’s tests.
First, focusing on the effects of

mandatory

audit partner rotation (which is,
after all, the auditor rotation question of greatest practical import) necessarily limits
variation in the audit partner tenure variable. Chen et al. (2008) consider tenure of
5 years or less to be short, and tenure exceeding 10 years to be long. Carey and

Discussion of “Mandatory Audit Partner Rotation and Audit Quality” 397

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Simnett (2006) conclude that audit partner tenure must exceed 7 years to adversely
affect audit quality. But after mandatory rotation, Taiwanese auditors cannot serve
more than 5 consecutive years. As a result, while average audit partner tenure is
shortest in the mandatory partner rotation sample (1.5 years), average partner ten-
ure is not much longer in two of the three benchmark nonrotation samples (2.3
years for other clients whose partners are not required to rotate and 2.7 years for
clients whose partners voluntarily rotated).

5

Should we expect an audit partner ten-
ure difference of 0.8 to 1.2 years to materially affect audit quality? With the benefit
of hindsight, it is perhaps not surprising that there are no consistently significant
differences between the mandatory rotation sample and these two benchmark non-
rotation samples. In contrast, the primary significant difference that Chi et al.
(2009) find is between the mandatory rotation sample and the benchmark sample
where partners have the longest tenure (4.8 years) — that is, the mandatory rota-
tion sample in the prior year.
The second feature that likely reduces the power of the study’s tests is that the
archival audit literature sorely lacks sharp proxies for audit quality. As Chi et al.
(2009) carefully note, proxies such as abnormal accruals and earnings response
coefficients may be among the more popular measures used to date, but they are
nonetheless noisy measures of earnings quality, much less audit quality. The next
section expands on this issue.

4. Wanted: Sharper proxies for audit quality

Audit quality is unobservable. Most of the literature draws inferences about audit
quality based on traditional, noisy measures of earnings quality. Although the two
are related, they are by no means isomorphic. A high-integrity client can produce
high-quality earnings whether or not the audit is of high quality. Conversely, even a
high-quality audit cannot be expected to identify or adjust all of a client’s low-quality
reporting choices, so a high-quality audit does not guarantee high-quality earnings.

6

Two of the most popular measures of “audit quality” are abnormal accruals
(e.g., Johnson et al. 2002; Myers et al. 2003; Carey and Simnett 2006; Chen et al.
2008), and ERCs (e.g., Ghosh and Moon 2005). However, the popularity of such
measures does not mean that they are good proxies for earnings quality, much less
audit quality. To their credit, Chi et al. (2009) forthrightly acknowledge some of
the limitations of these proxies. In hopes of motivating future researchers to develop
sharper and more refined proxies for audit quality, we expand on their discussion.
Abnormal accruals are residuals from models of nondiscretionary (or normal)
accruals. The explanatory power of these models rarely exceeds 30–35 percent.

Is
it plausible that most of the variation in aggregate accruals is due to inappropriate
earnings management that auditors could have detected, but failed to eliminate?

That is the implication of using abnormal accruals to evaluate audit quality. Given
the modest explanatory power of these models and other well-known concerns
reviewed in McNichols 2000, it is not surprising that Jones, Krishnan, and Melendrez
(2008) find that most measures of abnormal accruals (including performance-
matched abnormal accruals such as those in Chi et al. 2009) do not have any
incremental explanatory power (beyond total accruals) in explaining extremely

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low-quality earnings as evidenced by Securities and Exchange Commission (SEC)
charges of fraudulent reporting. That is, the extraction of the “abnormal” portion of
accruals does not create a sharper indicator of alleged fraudulent reporting than the
use of total accruals.
With respect to ERCs, using share prices as a benchmark for evaluating earn-
ings quality implies that share prices correctly measure the firm’s fundamental value,
and thus earnings numbers that more closely reflect the information impounded in
prices are of higher quality. However, it appears that prices can diverge from fun-
damental value for extended periods (e.g., Lee 2001, 2008). If markets can be
fooled by complex or fraudulent financial reporting, share prices are a questionable
benchmark for identifying the quality of those financial reports — particularly low-
quality reports.

7

Finally, we find it a bit hard to believe that rotating one audit part-
ner would materially affect the extent to which a client’s reported earnings reflect
the same information priced by the market.
While an extensive stream of research has used abnormal accruals and ERCs
as proxies for audit quality, in the next section we argue that the archival audit liter-
ature has now progressed to the point where it is time to move on.

5. Conclusions and suggestions for future research

Chi et al. (2009) identify a pressing question of real practical import: Does manda-
tory audit partner rotation improve audit quality? Because audit partners are not
identified in North American audit reports, the authors capitalize on available
evidence from Taiwan. This is an excellent use of international data to address a ques-
tion of real importance in North America, but one that we cannot answer in a North
American context. The empirical work is consistent with current standard method-
ology. Although we take issue with the paper’s proxies for audit quality, this concern
applies to the voluminous stream of archival research on audit quality, of which
Chi et al. 2009 is simply one example.
Turning to directions for future research, both the audit firm rotation literature
and the audit partner rotation literature focus on the net effects of rotation, rather
than separately identifying the costs and benefits of rotation. Future research could
contribute by providing more insight into the specific costs and benefits. Because
rotation creates significant costs, it would be useful to know, for example, whether
and to what extent audit partner rotation leads to any measurable benefits at all.
With the benefit of hindsight, it seems apparent that the magnitude of any
effects of mandatory audit partner rotation would be modest. Particularly given the
limited cross-sectional variation in audit partner tenure and the noisy proxies for
audit quality, it is not surprising that the study does not find much empirical evi-
dence of an effect.
Future researchers who find themselves with a project where the results fail to
reject the null would do well to heed Greenwald’s 1975 advice on gracefully failing
to reject the null hypothesis. For example, he discusses the importance of provid-
ing convincing evidence that the empirical proxies have construct validity, and he
also suggests providing evidence on the size of an effect that the empirical analysis
would be able to detect. The idea is to demonstrate that the study fails to reject the

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null, not because the tests are insufficiently powerful, but rather because any effect
that exists is economically immaterial. Cready and Mynatt (1991) provide an
excellent illustration in their study of the price and trading volume reactions to the
release of firms’ annual reports (as distinct from earnings announcements). After
failing to reject the null hypothesis that there is no price reaction to the release of
corporate annual reports, Cready and Mynatt (1991) provide simulation evidence
demonstrating that if such a price reaction does exist, it is too small to be eco-
nomically consequential, because their methods would identify a reaction of any
meaningful magnitude.
Finally, our primary suggestion for future research is that as archival audit
research matures, it becomes increasingly necessary to move beyond the “usual
suspect” proxies borrowed from archival financial accounting research. As research-
ers address increasingly refined questions, the magnitude of hypothesized effects is
likely to become more subtle and the relations more complex, which requires more
powerful empirical methods, particularly sharper proxies of key constructs.
Development of sharper measures of audit quality would provide a major
breakthrough. This will require imagination and creativity. While this is a tall
order, researchers have cleverly developed and validated empirical proxies for
other unobservable theoretical constructs that were once thought to be unmeasurable.
For example, Barron, Kim, Lim, and Stevens (1998) use properties of analysts’
forecasts to develop proxies for uncertainty, consensus, common information, and
private information. Matsumoto (2002) develops a measure of managers’ total
guidance of analysts, which Wang (2007) refines to develop a measure of managers’
private guidance (before Regulation Fair Disclosure). Development of more
refined proxies for audit quality would in our opinion provide an equally, if not
more, significant contribution.
Sharper proxies for audit quality will undoubtedly capitalize on the institu-

tional features of the audit environment. For example, rather than focusing on
aggregate accruals, researchers could focus on specific accruals that (a) are eco-
nomically significant, (b) are not well explained in accompanying disclosures,
(c) are susceptible to manipulation, and (d) whose manipulation auditors are likely
to be able to detect. Examples include loan loss provisions of financial institutions
and insurers’ loss reserves. Field studies such as the Nelson, Elliott, and Tarpley
2002 analysis of managers’ decisions about how to attempt earnings management
and auditors’ decisions whether to respond by requiring adjustments to the finan-
cial statements may be helpful in identifying specific powerful contexts.
DeAngelo (1981, 186) defines the quality of audit services as the “market
assessed joint probability that a given auditor will

both

(a) discover a breach in the
client’s accounting system, and (b) report the breach”. Researchers might incorporate
factors related to auditors’ ability to detect questionable reporting practices, such
as auditor industry specialization, auditor or audit firm experience, industry-specific
characteristics, client complexity, or audit firm alumni in client firm top manage-
ment. Factors related to auditors’ willingness to report or correct a questionable
reporting practice, such as the importance of the client, the effect of the practice on

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reaching an earnings target, the quality of the client’s corporate governance, or
other measures of independence, should also affect audit quality.

Researchers may be able to develop better measures of audit quality by combin-
ing several indicators into an index score. In addition to the indicators mentioned
above, research might also incorporate the client’s propensity to rarely just miss
and often just beat key earnings benchmarks, client financial restatements, allega-
tions of client fraudulent reporting, clients filing for bankruptcy after receiving a
clean opinion, the auditor’s propensity to issue qualified opinions, and lawsuits
against auditors. The chosen characteristics could be combined into a single index
score, and validated in a manner analogous to Botosan’s 1997 approach to develop-
ing and validating a disclosure index.
Finally, researchers may be able to identify direct measures of audit quality in
certain contexts, such as nonprofit firms’ compliance with GAAP disclosure
requirements (Krishnan and Schauer 2000), errors in insurance firms’ estimates of
claim loss reserves (Petroni and Beasley 1996), or ratings developed by government
agencies (Deis and Giroux 1992; Copley, Doucet, and Gaver 1994).

Endnotes

1. For example, the

Conceptual Framework for AICPA Independence Standards


recognizes the rotation of senior audit team members as an independence safeguard
(American Institute of Certified Public Accountants [AICPA] 2006).
2. Reflecting differences between audit firm tenure and auditor tenure, Bamber and Iyer
(2007) also find that individual auditors’ tenure is associated with greater identification
with the client, which in turn increases individual auditors’ acquiescence to the client’s
preferences.
3. We raise the issue of superficial audit partner rotation in Taiwan because this is a major
difference between the Taiwanese environment and the U.S. environment, where the

audit partner must remain rotated off for five years. In their empirical analysis, Chi et
al. (2009) appropriately exclude clients where one audit partner rotated off in 2003 and
rotated back on in 2004. The proportion of clients with this type of superficial rotation
is about 10 percent of their preliminary sample, which is, however, much lower than
the proportion Chen et al. (2008) report for 2003 and 2004. It appears that the
voluntary rotation benchmark group could include superficial rotation, if audit firms
engaged in superficial partner rotation in anticipation of the requirements for
mandatory rotation.
4. Chen et al. (2008, 419) recognize that the differences between their inferences and
Carey and Simnett’s 2006 inferences could be due to differences in research design
(e.g., 1-year versus 12-year sample periods) or to institutional differences between
Australia and Taiwan. Chen et al. also find that longer audit firm tenure is associated
with higher earnings quality, similar to results found in studies using U.S. data. Carey
and Simnett (2006) do not investigate the relation between audit firm tenure and
earnings quality. However, Chen et al. (2008) argue that because audit partner tenure is
strongly associated with audit firm tenure, Carey and Simnett’s (2006) evidence that
longer audit partner tenure is associated with lower quality earnings suggests that

Discussion of “Mandatory Audit Partner Rotation and Audit Quality” 401

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longer audit firm tenure may also be associated with lower quality earnings in
Australia, contrary to results based on U.S. data.
5. Part of the reason for the modest difference in audit partner tenure arises because each
engagement has two audit partners. Because the data do not distinguish the lead
partner, the authors take the average of the two partners’ tenure. As a result, partner
tenure can actually be shorter in the benchmark samples where rotation is not required
or where there was voluntary rotation. For example, client A has two partners who have

each served two years, so the average partner tenure is two years, and the partners are
not required to rotate. In contrast, client B is required to rotate and has one new partner
and one partner who has served four years, so the average partner tenure is two and a
half years.
6. For example, even a high-quality auditor cannot require adjustments for suspected
earnings management that the client achieved by structuring transactions to meet
specific and precise accounting standards.
7. Similarly, Kothari (2001, 132) notes that “the reasons why maximizing the earnings’
correlation with stock returns is desirable are not well articulated or proven logically”.

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