The relationship between audit firm tenure and probability of financial statement fraud.

Author:George, Nashwa
Position:Report
 
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  1. INTRODUCTION

    In recent years, several high-profile financial scandals involving Enron, Global Crossing, WorldCom and other major U.S. corporations have made the issue of financial reporting and audit quality as the focal point of concern for the U.S. law makers. In response to public outcry for restoring the credibility and public confidence in the audit and financial reporting process, the Congress enacted the Sarbanes Oxley Act (SOA) of 2002. Among various provisions, the SOA considered audit firm tenure as a potential area that needed to be investigated because the consecutive years of auditor-client relationship has the potential to impair auditor objectivity in certification functions. The SOA Section 207 required the Government Accountability Office, formerly General Accounting Office (GAO) to study the potential effect of mandatory audit firm rotation. The GAO in its report concludes that "mandatory audit firm rotation may not be the most efficient way to strengthen auditor independence." The GAO further suggests that the mandatory audit firm rotation becomes necessary if the SOA's other requirements do not lead to improved audit quality. It is not clear whether mandatory audit firm rotation solves the financial reporting problems. Arel, Brody and Pany (2005) suggest, "Mandatory audit firm rotation appeals superficially to many, yet the net effects of rotation are far from certain."

    This study examines the relationship between the probability of financial statement fraud and the audit firm tenure (expressed in terms of number of years' continuous audit engagement for a client). The study is an extension of several recent research performed to investigate the effect of auditor tenure on audit and financial reporting quality. Those studies concluded that shorter audit firm tenure is most likely to be associated with fraudulent financial reporting and audit failure. However, they do not find any relationship between longer audit firm tenure and reduced financial reporting quality. This study uses five quantitative indicators of financial statement fraud (as developed by Beneish, 1999) and empirically tests their association with the audit firm tenure. These fraud indicators help directly evaluate the presence or absence of a potential fraud situation in financial reporting (Beneish, 1999) and thus constitute a different measure of financial reporting quality from the ones employed in prior research. The objective is to examine whether an extended auditor-client relationship exacerbates the risk of financial statement fraud. Based on a sample of 350 firms listed on New York Stock Exchange with fiscal year end in 2006, the cross-sectional multivariate regression analysis produces evidence that four out of five fraud indicators are significantly, negatively related to the number of consecutive years of audit firm-client relationship. The result suggests that the longer the audit firm tenure, the lower is the probability of financial statement fraud. The results suggest that long audit firm tenure does not lead to distortion of reported financial information. If there is any effect of long auditor tenure on financial reporting, such effect is to reduce the probability that client management engages in manipulation of reported financial numbers. Furthermore, the observed negative relationship implies that the probability of financial statement fraud is greater in the initial years of auditor engagement.

  2. BACKGROUND AND DEVELOPMENT HYPOTHESES

    The importance of auditing in financial reporting process is under-scored by the fact that financial statements are joint products of audit firms and company management. Audit's effectiveness to enhance financial reporting quality depends partly on auditor's ability to detect material misstatements and partly on the auditor's behavior subsequent to the detection of such misstatements. Financial statements fraud is executed by management through manipulation of various accounting numbers. Auditor's ability to decipher those activities and report or to act as a deterrent to fraudulent financial reporting indicates the professional efficiency of the entire audit management process. This professional efficiency is ensured by both the auditor's acquisition and development of in-depth client specific knowledge (competence) and the auditor's ability to report material misstatements detected during the audit (independence). Regulators fear that the longer auditor-client relationship might reduce auditor independence and lead to auditor-client collaborative efforts to produce distorted financial information.

    Since the long auditor-client relationship is viewed as helping develop an economic bond between auditor and client, the subject of audit firm tenure is increasingly being associated with the impairment of auditor objectivity in certification function, i.e., audit failure to detect and report fraudulent financial reporting. The apprehension that auditors sacrifice their independence for the sake of close and long-lasting relationship with their clients leads the policy makers to consider the enactment of mandatory audit firm rotation as a possible means to improve financial reporting quality (Johnson et al, 2002).

    Reynolds and Francis (2001) suggest that reputation protection and litigation risk dominate auditor's reporting behavior. Consistent with this view, Arel et al. (2005) suggest that a close auditor-client relationship may not present a problem if the auditor can remain objective during audit process and provide a reliable opinion on the company's financial statements. But the proponents of mandatory audit firm rotation believe that the extended audit firm tenure impairs auditor independence leading to poor quality financial information. Regulators suggest a link between auditor tenure and reductions in earnings quality and hope that mandatory audit firm rotation is a possible solution (U.S. Senate, 1977; AICPA, 1978; Berton, 1991; SEC, 1994). However, the accounting profession argues that mandatory auditor rotation increases start up costs of audit firms and the risk of audit failure as the new auditors have to increasingly rely on client staff for accounting estimates and representations in the initial years of engagements (Meyers et al, 2003). Casterella et al. (2002) in their study on the relation between auditor tenure and fraudulent financial reporting find evidence that audit failures are more (less) likely when auditor tenure is long (short).

    The opposite view is that less client specific knowledge in the early years of auditor engagement may result in a lower likelihood of detecting material misstatements. Knapp (1981) argues that client-specific knowledge creates a significantly steep learning curve for new auditors. Auditors with long tenure have comparative advantage in this respect as they develop client-specific knowledge and deeper understanding of clients' business process and risk (Beck, Frecka and Soloman, 1988). Carcello and Nagy, 2004-CN; Johnson, Khurana and Reynolds, 2002-JKR; Meyers, Meyers and Omer, 2003; Ghosh and Moon, 2005). Both CN and JKR find evidence that fraudulent financial reporting is most likely to occur in the first three years (termed as "short" tenure) of auditor-client relationship. They, however, do not find any evidence that longer audit firm tenure (i.e., nine years or more) is associated with reduced financial reporting quality. Meyers, Meyers and Omer (2003) examine the association between audit firm tenure and earnings quality where auditor-client relationship lasted for at least five years. They observe that longer auditor tenure constrains managerial discretions with accounting accruals, which suggests high audit quality (i.e. audit firm tenure is negatively related to both the absolute discretionary and current accruals and signed positive discretionary and current accruals, and positively related to both the signed negative discretionary and current accruals). Geiger and Raghunandan (2002) find that...

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