Academic journal article The Journal of Developing Areas

Audit Firm Tenure and Earnings Management: The Impact of Changing Accounting Standards in UK Firms

Academic journal article The Journal of Developing Areas

Audit Firm Tenure and Earnings Management: The Impact of Changing Accounting Standards in UK Firms

Article excerpt

(ProQuest: ... denotes formulae omitted.)

INTRODUCTION

This study investigates the association between audit firm tenure and earnings management (EM) in the UK. Prior research generally provides evidence that longer audit firm tenure is associated with lower levels of EM and, therefore, higher earnings quality (e.g., Gul, Fung & Jaggi, 2009; Johnson, Khurana & Reynolds, 2002; Myers, Myers & Omer, 2003). This study is timely and important given the recent concerns regarding the potential compromise of auditor independence that might be associated with extended audit firm tenure (see for e.g. Moore, Tetlock, Tanlu & Bazerman, 2006; Sinnett, 2004). Many of the scandals occurred in the history of accounting and auditing were related to EM and external audit firms. Consequently, in order to avoid such scandals, The American Congress passed the Sarbanes-Oxley Act in 2002. One of these scandals was the Enron Scandal. The CEO kept huge debts off balance sheets of the famous Houston-based commodities, energy and service corporation "Enron". Accordingly, shareholders lost $74 billion and many employees lost their jobs. Arthur Andersen was found guilty of fudging Enron's accounts.

These concerns led to calls for mandatory auditor rotation. The Sarbanes Oxley Act of 2002 (SOX) mandates the rotation of audit partners every five years but does not require the mandatory rotation of the audit firm itself. However, the General Accounting Office (GAO) in the United States called for more research in this area as it indicated that mandatory audit firm rotation may strengthen auditor independence at least in appearance if not in fact (GAO, 2003). In Europe, the European Parliament issued directive 2006/43/EC which requires the mandatory rotation of audit partners within a maximum period of seven years and allows, after discussion with the audit committee, mandatory rotation of the audit firm itself in cases where the member state believes that it is important to safeguard auditor independence. In the UK, the Accounting Practices Board (APB) Ethical Standard 3 (Long Association with the Audit Engagement) requires mandatory partner rotation every five years but allows for an extra two years if the audit committee agrees that there are no threats to auditor independence.

In this paper, we test whether the accounting standards used by a firm play a moderating role in the association between audit firm tenure and EM in the UK. The UK context provides a rich environment to test this moderating effect. In the UK, two sets of accounting standards have been applied at the same time, as the mandatory adoption of International Financial Reporting Standards (IFRS) was required for group listed companies in the main market since January 2005 and for AIM group companies since January 2007. However, other individual listed companies and private companies have the choice between IFRS and UK GAAP. Such an environment allows us to test the association between audit firm tenure and EM in a period of a change from UK GAAP to IFRS.

Operationally, we compare the effect of audit firm tenure on EM for a group of firms which were continually reporting under UK GAAP versus another group of firms which were reporting under UK GAAP and then moved to IFRS - the mandatory adoption of IFRS started for group listed companies in January 2005. We argue that the change of accounting standards will make the auditor go through a new learning process and, therefore, the association between audit firm tenure and EM should no longer be valid for the subsample which moved to IFRS; whereas, we expect to find a valid association for the UK GAAP subsample. The purpose of this study is to contribute to the audit firm tenure and EM literature in two folds. First, we test whether the association between audit firm tenure and EM is conditional on the same set of accounting standards being applied. Second, to the best of our knowledge, this is the first study to empirically investigate the association between audit firm tenure and EM in the UK. …

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