Florida International University College of Business



Investor Reaction to the Prospect of Mandatory Audit Firm RotationJoseph V. CarcelloUniversity of TennesseeLauren C. ReidUniversity of TennesseeFebruary 25, 2013VERY PRELIMINARY – PLEASE DO NOT QUOTE OR CITE WITHOUT PERMISSION FROM THE AUTHORS Investor Reaction to the Prospect of Mandatory Audit Firm RotationSUMMARY: The PCAOB is currently discussing the implementation of mandatory audit firm rotation in hopes of better aligning auditors’ interests with investors’ interests. Through the receipt of comment letters in response to the August 16, 2011 Concept Release, the Board has heard from important constituents including management of public companies, audit committee members, and audit firms. The PCAOB, however, received very few comment letters from investors. This study provides insight into investors’ views of forced rotation by evaluating the market’s reaction to this potential policy. The results reveal that most investors oppose mandatory firm rotation. In particular, investors are more opposed to forced rotation if the company in which they invest currently employs an industry specialist as an auditor, is a large public issuer, or utilizes a Big 4 auditor. Furthermore, investors appear to be opposed to mandatory rotation regardless of the tenure of the current auditor. Keywords: mandatory audit firm rotation; market reaction; PCAOB; investor perception.VERY PRELIMINARY – PLEASE DO NOT QUOTE OR CITE WITHOUT PERMISSION FROM THE AUTHORSI. INTRODUCTION“[I]n recent years, we have seen an equally significant spike in deficiencies. Year in, year out, inspectors find deference to management in key reporting areas. For example, in the critical area of fair value reporting of financial instruments, instead of skeptically testing the reasonableness of managements’ assumptions and resulting assertions, one firm’s method involved obtaining valuations from a number of external parties and picking the one that is, ‘closest to the pin’ – the pin being management’s claimed value. … the explicit acknowledgement that the test was designed to support management’s number – the ‘pin’ – calls into question whether the auditor approached the audit with appropriate skepticism.” (PCAOB Chairman James Doty 2012).As a result of the Public Company Accounting Oversight Board’s (PCAOB or Board) concern about auditors’ lack of professional skepticism, the Board has reopened a debate that began over thirty years ago and is considering whether indefinite tenure aligns the auditors’ interests with management rather than guarding investors’ interests. One commonly recommended solution to this issue is mandatory audit firm rotation. Proponents argue that mandatory audit firm rotation results in management being less able to influence auditors’ decisions and auditors being less inclined to issue reports that favor management (Ruiz-Barbadillo 2009). Another common argument for mandatory audit firm rotation is that a new auditor provides a “fresh look” at the company and its financial reporting (Lu and Sivaramakrishnan 2009). This different perspective can also improve audit quality and enhance independence. On the other hand, some argue that the loss of in-depth knowledge of the client and its industry reduces the effectiveness of the audit (Lu and Sivaramakrishnan 2009). Opponents of forced rotation also believe that audit firm rotation is unnecessary as appropriate safeguards are already in place, including audit partner rotation, audit committee independence, peer reviews, the normal turnover of engagement teams, threat of audit firm reputation loss, and risk of audit firm litigation (GAO 2003; Ruiz-Barbadillo 2009). Opponents also cite academic literature on auditor tenure that finds mixed results regarding the effects of long tenure on audit quality. Some of this research notes that audit quality suffers during the earlier years of the client relationship and leads to more instances of fraudulent financial reporting (Geiger and Rahunandan 2002; Carcello and Nagy 2004). Mandatory audit firm rotation has recently received increased attention within the United States as the PCAOB issued a Concept Release that presented the possibility of rotation, and initiated the process of examining its merits and drawbacks. While it is impossible to gather U.S. archival evidence on the effects of a potential policy, it is feasible to study whether or not investors might value the policy. By examining the U.S. stock market reaction to the August 16, 2011 issuance of the PCAOB’s Concept Release, we examine how investors view the possibility of mandatory audit firm rotation. By studying investor reaction to this potential regulation, we provide insight into the perspective of the group, investors, that rotation is meant to protect. Furthermore, the PCAOB received well over 600 comment letters in response to the Concept Release (Franzel 2012), but less than ten percent were from investors and their responses were mixed. Therefore, it remains an empirical question as to whether investors support or oppose mandatory audit firm rotation. In addition to testing for an overall stock market reaction, we primarily investigate if investor reaction differs based on firm and auditor characteristics. The results of these additional analyses may be particularly informative to the Board as they reveal the possible triggers of investors’ reactions to the prospect of mandatory audit firm rotation. Overall, we find a significant and negative market reaction to the release of the Board’s Concept Release on mandatory audit firm rotation, suggesting that most investors oppose mandatory audit firm rotation. Specifically, the mean cumulative abnormal return during the two days following the August 16, 2011 issuance of the PCAOB Concept Release is -2.53%., where the cumulative abnormal market return is calculated using an index of foreign stock returns since these firms would have been less effected by the issuance of the PCAOB’s Concept Release. In addition, even though we calculate abnormal returns using a foreign stock index, we do not have a U.S.-specific control group – all firms registered with the SEC would be affected by any change in PCAOB policy regarding firm rotation – therefore, we focus primarily on our cross-sectional tests. We examine whether there is a differential market reaction based on company size, audit firm industry specialization, Big 4/non-Big 4 dichotomy, and audit firm tenure. Based on these cross-sectional tests of firm and auditor characteristics, we find that large public issuers have a significantly more negative reaction to the prospect of mandatory rotation than smaller public issuers. Furthermore, firms with an industry expert as an auditor experience a significantly more negative market reaction than firms without an expert auditor. We also find evidence that firms audited by Big 4 accounting firms react more negatively to the discussion of mandatory rotation compared to firms audited by non-Big 4 firms. In addition, we do not find evidence that the market reaction differs for firms with long auditor tenure compared to firms with shorter auditor tenure. This study contributes to the debate on firm rotation by providing the PCAOB and other regulators with relevant and timely information regarding the market reaction to the Board’s Concept Release. As regulators are considering the implementation of this regime in order to protect investors, it is interesting to note the negative market reaction to the possibility of mandatory auditor rotation. Furthermore, it appears that investors respond negatively to the discussion of mandatory rotation as they value the expertise of their current auditor and perhaps believe that any potential benefits of rotation, such as improved independence, would likely be outweighed by its costs. It also appears that investors view rotation as especially undesirable for large public issuers and companies utilizing a Big 4 auditor. In addition, this study indicates that investors did not react differently based upon auditor tenure, which is particularly interesting given the motivation to introduce rotation in order to curb independence issues related to long auditor tenure. The remainder of the paper is organized as follows. Section II provides further background on mandatory audit firm rotation and develops our hypotheses. Section III describes our research method, and Section IV presents our results. The last section discusses limitations and concludes. II. BACKGROUND AND HYPOTHESES PCAOB Consideration of Mandatory Firm RotationAs stated previously, PCAOB Chairman Doty has expressed concern that long auditor-client relationships can create an incentive to please the client. This perverse motivation clouds the auditors’ judgment and can cause a lack of professional skepticism as well as a failure to obtain sufficient audit evidence. Doty believes that steps need to be taken to shift the auditors’ “mindset to protecting the investing public” and that “it is incumbent on the PCAOB to take up the debate about firm tenure and examine it, with rigorous analysis and the weight of evidence in support and against [it]” (Doty 2011). As a result of Mr. Doty’s concerns, the PCAOB is considering requiring mandatory audit firm rotation in order to achieve “increased confidence in financial reports, if not outright improvement in the accuracy and completeness of these reports” (IAG 2011a). Also, certain members of the PCAOB’s Investor Advisory Group believe that it is appropriate to consider the issue of mandatory firm rotation as the financial crisis provided the “first test” of the effectiveness of SOX and, in the minds of some, auditors failed in ensuring the appropriateness of financial reporting (IAG 2011b). On August 16, 2011, the PCAOB issued a Concept Release to solicit public comment on ways to enhance auditor independence, skepticism, and objectivity, including the introduction of a mandatory audit firm rotation policy. The Concept Release presented numerous questions regarding the benefits and costs of mandatory audit firm rotation and also requested input as to how such a policy would be implemented. The Board, for example, invited discussion as to whether rotation should only be required when auditor tenure exceeds 10 years and only for audits of the largest firms. The Board welcomed feedback on these issues and received an overwhelming number of responses from audit firms, public companies, audit committee members, academics, associations, and investors during the comment period. The document also discussed the common arguments that have been made for and against rotation over the years. The Board noted that firm rotation has often been dismissed by academics and professionals based upon the argument that audit quality is lower in the first few years of an engagement, but the Board points out that these studies and arguments are grounded in an environment where rotation is voluntary (PCAOB 2011).The possibility of mandatory firm rotation was discussed when Congress was drafting the Sarbanes-Oxley Act of 2002. However, Congress determined that more research was needed to see if audit partner rotation, among numerous other measures, was sufficient in addressing independence concerns. Therefore, Section 207 of SOX commissioned the Government Accountability Office (GAO) to study mandatory firm tenure limits. In 2003, the GAO issued a report stating that the SEC and PCAOB would need several more years to determine whether or not the SOX reforms provided enough protection for investors against entrenched audit firms. The GAO concluded that audit firm rotation ‘‘may not be the most efficient way to strengthen auditor independence and improve audit quality’’ (GAO 2003). Over the past eight years, the PCAOB has conducted almost two thousand audit firm inspections (Hanson 2012) and has found several hundred audit failures (Doty 2011). As a result of continuing problems as revealed by inspection findings, the PCAOB is reconsidering whether mandatory audit firm rotation would improve audit quality.Evidence in Favor of Mandatory Audit Firm RotationProponents of mandatory audit firm rotation argue that long tenure impairs the independence of the auditor. This argument is grounded in the theory developed by DeAngelo (1981), which states that a client provides the audit firm with an annuity of quasi-rents that it expects to receive throughout its relationship with the client. This incentivizes the auditor to make sacrifices in order maintain the client relationship and guarantee its annuity, which can diminish auditor independence (DeAngelo 1981). Similarly, Gietzmann and Sen (2002) suggest that the ability of an audit firm to preserve its client relationships and thus its future audit fees can lead to implicit collusion between management and the auditors. Several behavioral studies have investigated the potential benefits and costs of imposing mandatory audit firm rotation, and these studies generally are supportive of audit firm rotation. Dopuch et al. (2001) experimentally test the effect of regulating firm rotation on auditor independence and find that such a policy decreases the auditor’s propensity to issue reports that please management and thus increases independence. In a similar vein, Wang and Tuttle (2009) perform an experiment to test the impact of rotation on the negotiation process between clients and auditors. The authors discover that in the absence of mandatory firm rotation, auditors are more concerned with appeasing management and tend to use “obliging” strategies in negotiation whereas with a mandatory rotation regime, auditors are less concerned about their relationship with management and tend to use “inaction” strategies (Wang and Tuttle 2009). Finally, Daniels and Booker (2011) find that bank loan officers view auditors as more independent when an audit firm rotation policy exists, although the presence of a rotation policy does not affect loan officers’ perceptions of audit firm quality. Conversely, in a study where MBA students were used as subjects to proxy for nonprofessional investors, Kaplan and Mauldin (2008) find that a rotation policy does not affect these subjects’ views of the extent of auditor independence. Nagy (2005) collects data within the United States where a forced auditor change occurred, although not as a result of mandatory firm rotation. He uses the demise of Arthur Andersen to gather archival evidence on the effects of a mandatory audit change on audit quality. Using the absolute value of discretionary accruals as a proxy for audit quality, he finds that a forced change in auditors increases audit quality for relatively small companies (Nagy 2005). In addition, some local governments require mandatory firm rotation. For example, some jurisdictions in Florida require audit firm rotation whereas others do not. Lowensohn et al. (2007) find that financial reporting quality is higher in those Florida jurisdictions that require rotation as compared to those jurisdictions that do not. While research surrounding mandatory firm rotation in the United States is limited, foreign settings where rotation is currently in place or once was implemented provide the ability to more directly study rotation’s effects. Chung (2004) examines companies in Korea before and after the passage of its mandatory rotation rule. The author reports lower discretionary accruals subsequent to the implementation of the requirement, which suggests that audit quality improved due to the enhanced incentives to maintain auditor-client independence (Chung 2004). Kwon et al. (2010) also study Korea’s mandatory audit firm rotation regime; however, Kwon et al. find different results. They find that audit hours and fees increased, but that audit quality (measured using abnormal discretionary accruals) remained unchanged or slightly decreased. In addition, prior studies on auditor tenure and audit quality might provide some information on the benefits and drawbacks of audit firm rotation. However, it is important to carefully extrapolate from studies using regimes where auditor turnover is voluntary to regimes where auditor turnover would be mandatory (Casterella and Johnston 2013). Notwithstanding this caveat, there are a number of studies that examine auditor tenure and various financial reporting and market outcomes. Davis et al. (2009) analyze the relation between auditor tenure and earnings management in pre- and post-SOX eras. Davis et al. find that prior to the passage of SOX, auditor-client relationships lasting fifteen years or more are associated with higher levels of accruals earnings management (Davis et al. 2009). However, post-SOX, they find no significant relation between tenure and earnings management. This change in the relation between auditor tenure and earnings management might be due to auditor performance being more closely scrutinized post-SOX, and also due to an increased risk of regulatory action against auditors (Davis et al. 2009). Additionally, Dao et al. (2008) use voting on auditor ratification as a proxy for investor perceptions and discover a significant association between shareholders not voting or voting against auditor ratification and long auditor tenure, suggesting that investors view long auditor tenure negatively. Evidence Against Mandatory Audit Firm RotationOpponents of firm rotation suggest that forcing auditors to be engaged by the same client for a relatively brief period would cause an overall decrease in audit quality as auditors with less exposure to the client do not have the necessary knowledge and expertise to ensure the appropriateness of the client’s financial statements (Moritz 2012). Elitzur and Falk (1996) attempt to model periodic rotation and find that a finite engagement period negatively affects planned audit quality until the last audit period. Comunale and Sexton (2005) model the effects of firm rotation on the market shares of public accounting firms and reveal the detrimental impact rotation has on auditor independence as well as quality. Kornish and Levine (2004) examine mandatory firm rotation from the audit committee perspective and argue that such a policy prevents the audit committee from using threats of dismissal to punish the auditor. More recently, Lu and Sivaramakrishnan (2009) provide a theoretical model that reveals the investment inefficiency created by a mandatory firm rotation regime. From 1989 to 1995, mandatory rotation existed in Spain. In an archival study, Ruiz-Barbadillo et al. (2009) use this context to test the effects of the rotation requirement on auditor independence. By examining auditors’ likelihood to issue going-concern opinions to financially distressed firms during and after the mandatory period, Ruiz-Barbadillo et al. (2009) find that the required rotation did not affect the auditors’ incentives. Specifically, the authors discover that, regardless of the regulation, auditors are not incentivized by their desire to retain clients, but are incentivized by the desire to maintain their reputation (Ruiz-Barbadillo et al. 2009). SDA Bocconi (2002) studies the effects of mandatory rotation on auditor independence in Italy and finds the greatest number of qualified opinions in the third year of the engagement period, which the authors believe is due to the fact that auditors require three years to gain an in-depth knowledge of the client. The SDA Bocconi study also reports that clients would retain their auditor for a longer period of time if the regulation did not require them to switch auditors by the end of the ninth year (SDA Bocconi 2002). In addition to Nagy (2005), two other studies examine forced auditor changes around Arthur Andersen’s demise, but unlike Nagy these studies do not find an improvement in financial reporting quality. Blouin et al. (2007) partition former Andersen clients where the prior audit team follows the client to the new audit firm, and where the former Andersen client is served by a different audit team (i.e., the proxy for the situation under mandatory firm rotation). Blouin et al. do not find a significant improvement in audit quality when a different audit team is used, and conclude that their finding is inconsistent with mandatory firm rotation improving financial reporting. Kealey et al. (2007) find that new auditors charge former Andersen clients higher fees given longer prior tenure, suggesting that auditors view a longer prior tenure with Andersen as an indication of heightened audit risk. A number of studies on auditor tenure find that longer auditor tenure is not problematic, in substance or in appearance. Geiger and Raghunandan (2002) examine firms in the years preceding bankruptcy and find a significant increase in audit reporting failures for firms in the early years of their audit tenure compared to longer auditor-client relationships. Johnson et al. (2002) indicate that short tenure (defined as three years or less) is associated with higher levels of unexpected accruals, and they do not find a difference in unexpected accruals between clients with medium auditor tenure as compared with clients with long auditor tenure (defined as nine years or more). Carcello and Nagy (2004) find that fraudulent financial reporting is more prevalent when the audit-client relationship is short and no more prevalent when the auditor tenure is long as compared to medium. Myers et al. (2003) find that higher earnings quality, as measured by absolute abnormal and current accruals, is associated with longer auditor tenure. Ghosh and Moon (2005) reveal that firms are less likely to engage in earnings management if they have a long-term relationship with their auditor. Mansi et al. (2004) find that as auditor tenure increases, investors require lower rates of return on corporate bonds, which implies that investors value the development of an auditor-client relationship. Boone et al. (2008) examine whether or not investors price auditor tenure and note that a nonlinear relation exists between equity risk premiums and firm tenure. The authors find that equity risk premiums decrease with increasing auditor tenure, until the thirteenth year after which the relation becomes positive (Boone et al. 2008). Overall, the literature on auditor tenure is frequently cited in the mandatory firm rotation debate, but due to the mixed results of these studies, it remains difficult to disentangle the impact of tenure on audit quality and independence. Lim and Tan (2010) argue that the conflicting conclusions may be attributable to the failure to consider the effects of auditor expertise and fee dependence. The authors find that with long auditor tenure, audit quality increases when the auditor is an industry specialist and the quality enhancement is even greater when the auditor has a lower fee dependence on its client (Lim and Tan 2010). HypothesesWe first examine whether or not investors as a whole reacted to the August 16, 2011 issuance of the PCAOB’s Concept Release. According to Schwert (1981), a new regulation that could affect future cash flows will result in a change in asset prices as soon as the market anticipates the regulatory change. If implemented, mandatory firm rotation could greatly affect a firm’s future cash flows given the likely increase in costs borne by the firm to deal with new auditors on a more frequent basis and the potential increase in audit fees as the new auditors spend more time familiarizing themselves with the firm. On the other hand, mandatory audit firm rotation, if effective in improving audit quality, would serve to reduce information risk. As a result of reduced information risk, investors should apply a lower discount rate in evaluating the present value of the cash flow stream associated with an equity investment which serves to increase the stock price. Prior research supports this supposition between the quality of accounting information and a firm’s cost of capital (Lambert et al. 2007). Examining the market reaction to an event where the prospect of mandatory audit firm rotation was formally introduced provides an opportunity to assess the expected benefits and costs of the policy (Choi et al. 2008). If the market anticipates that rotation will benefit the firm in the future, then the market reaction should be positive. If investors, however, are concerned that the potential benefits of rotation will be outweighed by its costs, then the market reaction will likely be negative (Choi et al. 2008). As either a negative or positive reaction is plausible, we state the following null hypothesis: H1: There will not be a significant market reaction, as measured by cumulative abnormal returns, on the dates surrounding the issuance of the PCAOB’s Concept Release on mandatory firm rotation.In addition, we partition the sample to determine cross-sectional differences in market reactions based upon important firm characteristics. While all U.S. public companies are likely to be subject to mandatory firm rotation if implemented, it is unlikely that they would all be affected by this policy in the same way. Therefore, the partitioning of the sample allows for the examination of the varying views investors hold of periodic rotation in light of the specific attributes of the companies in which they invest. As one of the main arguments cited in opposition to rotation revolves around the loss of auditor knowledge and experience, we first partition the sample based on whether or not the firm’s current auditor is an industry expert. If investors value the expertise of their current auditor and believe that it would be difficult to replace an industry expert in the event of forced rotation, investors of firms with an expert auditor will react more negatively to the discussion of mandatory audit firm rotation. If, however, investors value the fresh perspective gained from switching auditors, investors of firms with an expert auditor will not react differently than investors of firms without an expert auditor. As numerous comment letters referenced the fear of losing auditor expertise, we expect investors of firms audited by an industry expert to react negatively to the discussion of mandatory audit firm rotation. We therefore hypothesize the following:H2a: Firms with an industry expert as an auditor will experience lower cumulative abnormal returns on the dates surrounding the issuance of the PCAOB’s Concept Release on mandatory firm rotation. Next, we partition the sample based upon auditor tenure. The Concept Release specifically mentioned that the rotation requirement may only apply to firms with tenure greater than ten years. It is therefore important to examine whether the market reaction differed for firms with varying lengths of auditor tenure. If investors believe that auditor independence is compromised as a result of long auditor tenure (DeAngelo 1981; Gietzman and Sen 2002), then investors of firms with long auditor tenure should react more positively to the discussion regarding mandatory audit firm rotation because this policy would force the firm to switch auditors and perhaps enhance independence. If, however, investors value long auditor tenure because they believe that auditors are able to provide a more effective audit as tenure increases (Myers et al. 2003; Mansi et al. 2004; Boone et al. 2008), then investors of firms with long auditor tenure should react more negatively to these events. We predict that investors value the knowledge and experience attained with longer auditor tenure and therefore form the following hypothesis:H2b: Firms with long auditor tenure will be associated with lower cumulative abnormal returns on the dates surrounding the issuance of the PCAOB’s Concept Release on mandatory firm rotation.In addition, we partition the sample based on the size of the firm. The Concept Release posed the question of whether mandatory rotation should only apply to large issuers. As such, it is important to determine if investors of large firms responded differently than investors of smaller firms. While regulators may believe that large firms have a greater ability to absorb the additional costs that rotation may create, these firms may also experience the greatest challenges. The larger the firm, the more complex and extensive the audit required. As a result, the bidding and proposal process is much more time consuming and the transition costs are substantially larger. In addition, a larger firm is also more likely to operate internationally and will not only have to rotate firms within the United States, but will also have to make the necessary adjustments in its relationships with the auditor’s foreign affiliates that it employs. Also, large firms tend to engage in more complex accounting transactions that only a small subset of audit firms can properly assess. As such, we predict the following:H2c: Firms larger in size will experience lower cumulative abnormal returns on the dates surrounding the issuance of the PCAOB’s Concept Release on mandatory firm rotation. Another important distinction is whether or not a Big 4 accounting firm audits the company. If a firm is currently audited by a Big 4 firm, it likely requires the resources that a Big 4 firm is able to provide. Thus, if required to rotate, the firm would need to choose one of the other Big 4 auditors. Rotating between the Big 4 firms severely limits a company’s auditor choices and becomes nearly impossible if the company is using other Big 4 firms for various services, including tax and internal audit. Given the lack of options and the additional challenges rotation poses for firms audited by a Big 4 firm, we predict the following:H2d: Firms audited by a Big 4 accounting firm will experience lower cumulative abnormal returns on the dates surrounding the issuance of the PCAOB’s Concept Release on mandatory firm rotation. III. RESEARCH METHODTest of Overall Market ReactionTo test the overall market reaction to the prospect of mandatory audit firm rotation, we use a market model similar to the one utilized by Chaney and Philipich (2002) as well as Zhang (2007). This model determines the cumulative abnormal stock market returns (CARs) of all U.S. publicly traded firms. Specifically, we compute the CARs surrounding the PCAOB Concept Release on August 16, 2011 for all firms with data available through CRSP. The following market model is used to measure abnormal returns:Rit=αi+βiRmt+eitwhere:Rit= return for firm i on day tαi= interceptβi= beta for firm iRmt= return on the value-weighted MSCI world index, excluding the U.S., on day teit= error termThe abnormal return on day t is then calculated as:ARit=Rit-(αi+βiRmt)The market reaction is the cumulative abnormal return:CAR=t=0TARitIn addition to using the value-weighted MSCI world index excluding the United States (herein referred to as the “foreign market model”), we use the value-weighted CRSP index (herein referred to as the “U.S. market model”). Although we measure abnormal returns using both the foreign market model and the U.S. market model, we rely primarily on the foreign market model. As Zhang (2007) indicates, changes in the U.S. market model on the event days captures any effects of the PCAOB’s release on mandatory firm rotation as well as contemporaneous economic news. Thus, there is a need to control for normal returns in the U.S. market during our event window absent the effects of the PCAOB announcement. We use the foreign market model to estimate the impact of other economic news on U.S. returns during the event period. Prior finance literature, such as Eun and Shim (1989) and Hamao et al. (1990), finds that U.S. firms and foreign firms are exposed to “substantial common economic news” (Zhang 2007). The majority of foreign firms, however, are not affected by changes in U.S. regulation, including the potential implementation of mandatory audit firm rotation. Therefore, the foreign market model reflects the impact of global economic news affecting both U.S. and foreign markets but does not account for the impact of news related to mandatory firm rotation. Tests of Differences in Sample PartitionsAfter estimating the cumulative abnormal returns, we partition the sample in four different fashions and test the differences in stock market reaction: (1) firms with an industry expert as the auditor and firms without an industry expert as the auditor, (2) long auditor tenure and short auditor tenure, (3) large firms compared to small firms, and (4) firms audited by a Big 4 accounting firm and firms audited by a non-Big 4 accounting firm. Following Lim and Tan (2010), we define auditors with a large industry market share as an industry expert. The industries are based on two-digit SIC codes and the threshold for a “large” industry market share is 30 percent of the total industry sales (Neal and Riley 2004; Lim and Tan 2010). We measure auditor tenure as the cumulative number of years the audit firm has been engaged by the company (Lim and Tan 2010), and define long tenure as tenure greater than 10 years in order to isolate the group of firms specifically mentioned in the Concept Release. Firm size is measured as the natural log of the company’s market value of equity and the median value is used to separate large firms from small firms (Chaney and Philipich 2002; Zhang 2007). Big 4 is an indicator variable equal to one if the firm is currently audited by one of the Big 4 public accounting firms. Cross-Sectional Analysis56007002720340(1)0(1)In order to further test hypotheses H2a-H2d, we perform cross-sectional analyses to control for other factors that potentially influence market returns. We control for (1) firm performance by including sales growth, (2) firm growth opportunities by including the firm’s market-to-book ratio, (3) leverage, (4) earnings management by including the absolute value of abnormal accruals, (5) “burden” of audit costs by including audit fees as a percentage of a total operating expenses, (6) percent of institutional ownership, and (7) industry membership by including Fama-French 12 industry controls (Chaney and Philipich 2002; Zhang 2007; Li et al. 2008). All independent variables are determined as of the year prior to the event. CARit= β0+β1Expert+β2LongTenure+β3LargeSize+β4Big4+β5SalesGrowth+β6MTB+β7Leverage+β8HighAbsAccr+ β9HighFeeBurden+β10InstOwn+β11Industry+ εitwhere: Expert= 1 if audit firm market share is at least 30% of total industry sales, 0 otherwise.LongTenure= 1 if audit firm tenure is greater than 10 years, 0 otherwise. LargeSize = 1 if natural log of market value of equity is greater than or equal to the sample median, 0 otherwise. Big4 = 1 if the company is audited by a Big 4 firm, 0 otherwise. SalesGrowth= percentage growth in sales over the previous year. MTB= natural log of market value divided by the book value of equity.Leverage = long-term debt divided by total assets.HighAbsAccr= 1 if absolute abnormal accruals is greater than or equal to the sample median, 0 otherwise. HighFeeBurden= 1 if audit fees paid to auditor divided by total operating expenses is greater thanor equal to the sample median, 0 otherwise.InstOwn = percentage of institutional ownership in the company. Industry= Fama-French 12 industry controls (Fama and French 1997).εit = error term.Given the higher agency costs associated with rapid growth and leverage, there is greater demand for higher audit quality (DeFond 1992). As a result, if mandatory rotation is sub-optimal, firms experiencing rapid growth (proxied using SalesGrowth and MTB) and firms with more leverage may have a negative reaction to the prospect of forced rotation because these firms may benefit from the experience and knowledge provided by a long relationship with an auditor. However, these firms may have a positive reaction if rotation is beneficial by providing the fresh perspective that switching auditors provides. We also do not predict a direction for the earnings management indicator as investors in firms engaging in high levels of earnings management may prefer that management have the ability to manage earnings (i.e., smooth earnings are generally preferred to volatile earnings). Conversely, investors may be seeking a more independent and higher quality auditor to lessen the level of earnings management so that reported financial results more closely mirror actual financial results. In addition, we do not predict a direction for the fee burden indicator as it is unknown how audit fees will change should forced rotation be implemented. Audit fees might increase if auditors pass on any first year familiarization costs to the client. On the other hand, rotation may increase market competition for audit services, which could decrease audit fees. We also do not predict a sign on InstOwn as it is unknown how institutional investors view mandatory firm rotation.SampleWe obtain all necessary stock price data for U.S. companies through CRSP and require a minimum of 40 days of return data to be included in the parameter estimation of either the foreign or U.S. market model. We gather the value-weighted index returns for the foreign market model through Datastream and for the U.S. market model through CRSP. We exclude all financial firms from the sample as is common in prior studies. In order to be included in the multivariate regressions, the observation must contain the needed financial data from Compustat. Additionally, we require all observations to have the necessary audit fee data from Audit Analytics and institutional ownership data from Thomson Reuters. The final cross-sectional sample is comprised of 2,186 firms. While the final sample is comprised of substantially fewer observations than the total number of observations with stock returns available in CRSP, the sample represents over 70 percent of the entire market capitalization of U.S. companies. Furthermore, untabulated results indicate that the cumulative abnormal returns of the cross-sectional sample are comparable in magnitude and significance to the market-wide returns presented in Table 2. Please see Panel A of Table 1 for more detail regarding the sample selection procedure. Panel B of Table 1 tabulates the descriptive statistics of the cross-sectional sample. The companies in the sample have an average size of $3.4 billion. In addition, Big 4 firms audit over 73 percent of the sample and the average audit fee is $1.86 million. The mean auditor tenure of a sample firm is roughly 11 years and the maximum auditor tenure is 37 years. The average institutional ownership of a sample firm is 57.5 percent. <Insert Table 1 Here>IV. RESULTSOverall Market ReactionUsing both the foreign market model and the U.S. market model, we find significantly negative overall market reactions to the August 16, 2011 Concept Release over two, three, four, and five day windows. As shown in Panel A of Table 2, the foreign market model reveals that the market experienced cumulative abnormal returns of -2.53% in the (0,+1) window, -4.87% in the (0,+2) window, and -5.63% in the (0,+3) and (-1,+3) windows. Panel B of Table 2 presents returns using the U.S. market model. The cumulative abnormal returns range from -2.57% in the (0,+3) and (-1,+3) windows to -2.69% in the (0,+2) window. As expected, we find that abnormal returns are smaller when computed using the U.S. market model than the foreign market model. Returns estimated with a U.S. market index typically underestimate the impact of regulatory events because the whole market is affected by these events (Zhang 2007). <Insert Table 2 Here>Tests of Differences in Sample PartitionsIn order to further explore the market’s reaction to the prospect of mandatory audit firm rotation, we test for differences in investor reactions based upon firm characteristics. As shown in Panel A of Table 3, the market reaction is significantly more negative for firms with an industry expert (-7.02%) compared to firms without an expert (-6.24%) in the (0,+2) window. We also find a significant difference in the industry expert partition for the (0,+3) window. This result provides statistically significant evidence consistent with H2a that investors in firms with an industry expert auditor value the knowledge and proficiency of their auditor and therefore had a more negative reaction to the possibility of forced rotation. We do not find any support for H2b in the tests of partitions. As Table 3 reveals, there is not a significant difference in market reactions between firms with auditor tenure greater than 10 years and those with auditor tenure less than or equal to 10 years. This result provides some initial evidence that investors view the prospect of rotation negatively regardless of the length of auditor tenure. Consistent with H2c, Table 3 reveals that the cumulative abnormal returns are significantly more negative for large firms than small firms in all three event windows and in both models. For example, large firms experienced a -8.57% cumulative abnormal return in the (0,+3) window of the foreign market model compared to small firms that experienced a -6.38% market reaction. We also find support for H2d as the cumulative abnormal returns for companies audited by a Big 4 accounting firm are significantly more negative than the returns for companies audited by a non-Big 4 firm. The difference between these two types of companies is significant at the 1% level across all three event windows in both models. <Insert Table 3 Here>Regression ResultsTable 4 presents the estimation results of equation (1) in order to further investigate the cross-sectional variation in market reaction to the August 16, 2011 Concept Release. Panel A provides the results using the cumulative abnormal returns estimated by the foreign market model and Panel B presents the results using the U.S. market model. Across all regressions in both panels, Expert is negative and significant. This finding is consistent with H2a as it provides further evidence that investors in firms with an industry expert as an auditor reacted more negatively to the prospect of mandatory firm rotation than investors in firms without an industry expert. In the (0,+2) and (0,+3) windows, the coefficient on LargeSize is negative and significant for both models, which further confirms the results of the partition analysis that large firms responded more negatively than small firms to the prospect of forced rotation. Furthermore, Big4 is negative and significant in both models and across all windows except for the (0,+3) window in the U.S. market model. This finding provides further support for H2d as companies audited by a Big 4 firm are associated with lower cumulative abnormal returns. As LongTenure is insignificant across all regressions, it appears that investors responded negatively to the discussion of mandatory audit firm rotation regardless of the length of auditor tenure. In regard to the control variables, we find a significant and negative association between MTB and cumulative abnormal returns in both the foreign market model and the U.S. market model. This result provides evidence that high growth firms reacted more negatively to the Concept Release. There is also some limited evidence that firms with higher institutional ownership had a more negative reaction on August 16, 2011 as the coefficient on InstOwn was negative and significant in the (0,+2) and (0,+3) windows for the foreign market model. This result did not hold when returns were calculated using the U.S. market model. <Insert Table 4 Here>Date Sensitivity TestAn issue in any event study is the potential leakage of information prior to the dates examined. To alleviate concerns related to this problem, we investigate two earlier events that mentioned mandatory audit firm rotation. The first event was a meeting held by a working group of the Investor Advisory Group (IAG) which is an advisory group to the PCAOB. During a full day of meetings on March 16, 2011, members of the committee debated numerous topics, including the auditor’s report, the financial crisis, global networks and audit firm governance. Mandatory audit firm rotation was discussed as a potential mechanism to enhance auditor independence. Only presentation slides and webcasts were made available to the public from the meeting. The second event occurred on June 2, 2011 when PCAOB Chairman Doty addressed the SEC and Financial Reporting Institute 30th Annual Conference. In his speech, Doty discussed issues related to auditor transparency, independence, and professional skepticism as well as the auditor’s report. He also touched on how the Board is prepared to consider numerous methods of addressing the problem of audit quality including forced rotation. We examined the cumulative abnormal returns surrounding these two events, March 16, 2011 and June 2, 2011, to mitigate concerns regarding the leakage of information prior to the August 16, 2011 Concept Release. In untabulated tests, we found insignificant and inconsistent univariate as well as multivariate results for these earlier dates. As expected, it appears that the market did not factor in the future cash flow effects of rotation until the issuance of the Concept Release, which formally presented rotation and initiated the process to officially examine its implementation. Other Variable SpecificationsWe also perform cross-sectional tests that include variables specifically created to capture the complexity of a firm. Following Zhang (2007), we create a business line variable that is measured by the number of four-digit SIC industries of each firm as well as an indicator variable to measure a firm’s foreign operations and transactions. The foreign indicator variable equals one if the firm’s foreign currency adjustment is different from zero (Zhang 2007). We also include an indicator variable equal to one if a firm engaged in a merger or acquisition transaction in the last year. As the coefficients were not significant and did not change the inferences of the multivariate analysis, we do not report the regressions including these variables. We also test the following alternative specifications to define long auditor tenure: (1) if the auditor-client relationship is longer than the sample’s median length of auditor tenure (Lim and Tan 2010), (2) if the relationship is nine years or longer (Johnson et al. 2002, Carcello and Nagy 2004), and (3) if the relationship is fifteen years or more (Davis et al. 2009). Regardless of the specification, LongTenure remains insignificant in both the partition analysis as well as the cross-sectional tests. The other coefficients also remain qualitatively unchanged. V. LIMITATIONS AND CONCLUSIONAs in any event study, it is difficult to ensure that confounding events do not drive the documented market reactions. In order to address this issue, we searched Bloomberg News as well as The New York Times around the issuance of the PCAOB Concept Release. During the August 16, 2011 event window, the European debt crisis continued, but U.S. stocks experienced the biggest three-day rally since 2009 in the days prior to August 16th. Furthermore, Fitch Ratings affirmed its AAA credit rating for the U.S. government and retailers such as Wal-Mart and Home Depot experienced stock price increases while financial stocks including Bank of America and Citigroup declined. In addition, news of large mergers and acquisitions, including Google’s acquisition of Motorola, revealed economic improvements. While we cannot completely rule out the possibility that the abnormal market reaction on August 16, 2011 is affected by confounding events, the utilization of the foreign market model should lessen some of the concerns. Given the fact that the U.S. specific news was mostly positive during this time, including the affirmation of the government’s AAA debt rating and news of large acquisitions, we would expect any U.S. specific news to bias against finding a significant negative market reaction. The primary confounding event surrounding the August 16, 2011 window involved the European debt crisis, but the foreign market model should mitigate the effects of the debt crisis as the MSCI world index includes European countries that are equally and arguably much more affected by the crisis. In addition, and perhaps even more convincing, we would not expect to find the predicted differential impacts of firm characteristics on abnormal returns if the market reacted mostly to events outside of the mandatory firm rotation discussion. The PCAOB is currently discussing the implementation of mandatory audit firm rotation in hopes of improving audit quality and independence by better aligning auditors’ interests with investors’ interests. Through the receipt of comment letters, the Board has heard from important constituents including management of public companies, audit committee members, and audit firms. The PCAOB, however, received very few comment letters from investors in response to the August 16, 2011 Concept Release. This study provides insight into investors’ views of forced rotation by evaluating the market’s reaction to the PCAOB’s discussion of this potential policy.The results of this study reveal that most investors oppose mandatory audit firm rotation. 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TABLE 1: Sample Construction and Descriptive StatisticsPanel A: Sample Construction?????Number of firms with 2011 data from CRSP??7,083?Less: firms failing to meet minimum of 40 days of return data(625)Less: firms missing general Compustat data and financial firms(2,806)Less: firms missing auditor tenure data from Compustat(1,373)Less: firms missing audit fee data from Audit Analytics(11)Less: firms missing institutional ownership data from Thomson Reuters(82)?Number of firms in the final sample2,186Panel B: Descriptive Statistics?VariableMeanSDMinp25p50p75MaxExpert0.34310.47490.00000.00000.00001.00001.0000Tenure11.30799.38871.00005.00009.000015.000037.0000Size*3,427.159,702.569.83146.01572.082,152.1372,522.30Big40.73510.44140.00000.00001.00001.00001.0000AuditFees1.86243.03970.03600.39990.89931.900020.2000FeeBurden0.00430.00510.00010.00110.00240.00550.0294SalesGrowth0.20140.4762-0.72400.00450.10080.25093.1206MTB*2.85244.2796-16.7261.27862.00463.339322.7806Leverage0.19480.20460.00000.00290.14850.31380.9077AbsAccr 0.09630.13190.00080.01940.05070.11460.7802?InstOwn0.57470.30990.00180.31130.64510.84471.0000?N= 2,186 ??????Panel A provides details of the sample construction. Panel B provides descriptive statistics for the firms in the sample. Expert equals one if the audit firm market share is 30 percent or more of total industry sales and zero otherwise. Tenure is the cumulative number of years the audit firm has been engaged by the company. Size is the firm’s market value of equity in millions of dollars. Big4 equals one if the company is audited by a Big 4 accounting firm and zero otherwise. AuditFees is the company’s total audit fees incurred in the past year in millions of dollars. FeeBurden equals the company’s AuditFees divided by the company’s total operating expenses. SalesGrowth is the percentage growth in sales over the previous year. MTB is the market value divided by the book value of equity. Leverage is long-term debt divided by total assets. AbsAccr equals the firm’s level of absolute abnormal accruals. InstOwn is the percentage of institutional ownership in the company. All continuous variables are winsorized at 1 percent and 99 percent to avoid the potential effects of outliers. *For descriptive purposes, the Size and MTB variables are not reported in natural log form. TABLE 2: Overall Market Reaction to PCAOB Concept Release (N=6,458)?Panel A: Foreign Market Model??WindowCAR (%)p-value(-1,+3)-5.630.0000***(0,+1)-2.530.0000***(0,+2)-4.870.0000***(0,+3)-5.630.0000***Panel B: U.S. Market Model??WindowCAR (%)p-value(-1,+3)-2.570.0000***(0,+1)-2.650.0000***(0,+2)-2.690.0000***(0,+3)-2.570.0000****** p<0.01 (two-tailed)Table 2 presents the cumulative abnormal returns (CARs) surrounding the issuance of the PCAOB Concept Release on August 16, 2011. The CARs are calculated using the market model over two (0,+1), three (0,+2), four (0,+3), and five (-1,+3) day windows. Panel A presents the overall market reactions using the MSCI world index excluding the U.S. referred to as the foreign market model. Panel B presents the overall market reactions using the value-weighted CRSP index referred to as the U.S. market model.TABLE 3: Tests of Differences in Partitions for PCAOB Concept Release (N=2,186)Panel A: Foreign Market ModelExpert=1 (N=750)Expert=0 (N=1,436)DifferenceWindowCAR (%)p-valueCAR (%)p-valueMeanp-value(0,+1)-3.470.0000***-3.150.0000***-0.320.1460(0,+2)-7.020.0000***-6.240.0000***-0.780.0043***(0,+3)-8.180.0000***-7.110.0000***-1.070.0011***LongTenure=1 (N=790)LongTenure=0 (N=1,396)DifferenceWindowCAR (%)p-valueCAR (%)p-valueMeanp-value(0,+1)-3.320.0000***-3.230.0000***-0.090.6929(0,+2)-6.650.0000***-6.430.0000***-0.220.4286(0,+3)-7.710.0000***-7.340.0000***-0.370.2586LargeSize=1 (N=1,092)LargeSize=0 (N=1,094)DifferenceWindowCAR (%)p-valueCAR (%)p-valueMeanp-value(0,+1)-3.450.0000***-3.800.0000***0.350.0911*(0,+2)-7.370.0000***-5.650.0000***-1.720.0000***(0,+3)-8.570.0000***-6.380.0000***-2.190.0000***Big4=1 (N=1,607)Big4=0 (N=579)DifferenceWindowCAR (%)p-valueCAR (%)p-valueMeanp-value(0,+1)-3.430.0000***-2.790.0000***-0.640.0092***(0,+2)-7.070.0000***-4.960.0000***-2.110.0000***(0,+3)-8.150.0000***-5.610.0000***-2.540.0000***TABLE 3 (continued): Tests of Differences in Partitions for PCAOB Concept Release (N=2,186)Panel B: U.S. Market ModelExpert=1 (N=750)Expert=0 (N=1,436)DifferenceWindowCAR (%)p-valueCAR (%)p-valueMeanp-value(0,+1)-3.700.0000***-3.370.0000***-0.330.1029(0,+2)-4.220.0000***-3.610.0000***-0.610.0309**(0,+3)-4.240.0000***-3.410.0000***-0.830.0154**LongTenure=1 (N=790)LongTenure=0 (N=1,396)DifferenceWindowCAR (%)p-valueCAR (%)p-valueMeanp-value(0,+1)-3.570.0000***-3.430.0000***-0.140.5098(0,+2)-3.810.0000***-3.820.0000***0.010.9651(0,+3)-3.720.0000***-3.680.0000***-0.040.9043LargeSize=1 (N=1,092)LargeSize=0 (N=1,094)DifferenceWindowCAR (%)p-valueCAR (%)p-valueMeanp-value(0,+1)-3.730.0000***-3.230.0000***-0.500.0182**(0,+2)-4.450.0000***-3.190.0000***-1.260.0000***(0,+3)-4.460.0000***-2.930.0000***-1.530.0000***Big4=1 (N=1,607)Big4=0 (N=579)DifferenceWindowCAR (%)p-valueCAR (%)p-valueMeanp-value(0,+1)-3.700.0000***-2.880.0000***-0.820.0006***(0,+2)-4.160.0000***-2.870.0000***-1.290.0000***(0,+3)-4.050.0000***-2.690.0000***-1.360.0002***Table 3 presents results for the tests of differences in the cumulative abnormal returns (CARs) between the various sample partitions surrounding the August 16, 2011 issuance of the PCAOB Concept Release. Panel A presents the partition results using the MSCI world index excluding the U.S. referred to as the foreign market model. Panel B presents the partition results using the value-weighted CRSP index referred to as the U.S. market model. Expert equals one if the audit firm market share is 30 percent or more of total industry sales and zero otherwise. LongTenure equals one if the audit firm tenure is greater than ten years and zero otherwise. LargeSize equals one if the natural log of market value of equity is greater than or equal to the sample median and zero otherwise. Big4 equals one if the company is audited by a Big 4 public accounting firm and zero otherwise. *** p<0.01, ** p<0.05, * p<0.1 (two-tailed)Table 4: Regression Results for PCAOB Concept Release (N=2,186)Panel A: Foreign Market Model ????VARIABLESCAR (0,+1)CAR (0,+2)CAR (0,+3)????Intercept-0.0132***-0.0261***-0.0276***(0.0057)(0.0000)(0.0000)Expert-0.00412*-0.00555**-0.00770**(0.0746)(0.0499)(0.0282)LongTenure0.001330.004360.00454(0.5680)(0.1040)(0.1650)LargeSize-0.000827-0.00662**-0.00824**(0.7560)(0.0490)(0.0419)Big4-0.00574*-0.0124***-0.0126**(0.0841)(0.0035)(0.0135)SalesGrowth-0.00438-0.00508-0.00520(0.1920)(0.1960)(0.2640)MTB-0.00350**-0.00889***-0.00915***(0.0365)(0.0000)(0.0000)Leverage0.007340.00632-0.00930(0.3120)(0.4310)(0.3120)HighAbsAccr-0.00408*-0.00309-0.00350(0.0673)(0.2510)(0.2740)HighFeeBurden-0.00302-0.00306-0.00193(0.2400)(0.3310)(0.6030)InstOwn-0.00327-0.0212***-0.0235***(0.5690)(0.0007)(0.0019)Industry ControlsYesYesYesR-squared5.70%10.90%11.10%Robust p-values in parentheses*** p<0.01, ** p<0.05, * p<0.1 (two-tailed)Table 4 (continued): Regression Results for PCAOB Concept Release (N=2,186)?Panel B: U.S. Market Model?????VARIABLESCAR (0,+1)CAR (0,+2)CAR (0,+3)?????Intercept-0.0135***-0.0135**-0.0100(0.0046)(0.0187)(0.1300)Expert-0.00361*-0.00623**-0.00874**(0.0936)(0.0365)(0.0191)LongTenure0.001390.004450.00465(0.5180)(0.1050)(0.1700)LargeSize-0.0000-0.0105***-0.0138***(0.9940)(0.0017)(0.0007)Big4-0.00629*-0.00774*-0.00600(0.0500)(0.0822)(0.2740)SalesGrowth-0.00419-0.00325-0.00269(0.2040)(0.4140)(0.5770)MTB-0.00478***-0.00567***-0.00439*(0.0020)(0.0031)(0.0598)Leverage0.01030.00454-0.0124(0.1290)(0.5750)(0.1810)HighAbsAccr-0.00371*-0.00206-0.00215(0.0899)(0.4370)(0.4960)HighFeeBurden-0.00249-0.00292-0.00184(0.3220)(0.3600)(0.6280)InstOwn-0.00823-0.002800.00312(0.1140)(0.6870)(0.7160)Industry ControlsYesYesYesR-squared6.20%6.00%5.70%Robust p-values in parentheses?*** p<0.01, ** p<0.05, * p<0.1 (two-tailed)?Table 4 presents the regression results for the PCAOB Concept Release issuance on August 16, 2011. Panel A presents the results using the MSCI world index excluding the U.S. referred to as the foreign market model. Panel B presents the results using the value-weighted CRSP index referred to as the U.S. market model. In each panel, separate regressions are performed for the two, three, and four-day event windows. Expert equals one if the audit firm market share is 30 percent of total industry sales and zero otherwise. LongTenure equals one if the audit firm tenure is greater than ten years and zero otherwise. LargeSize equals one if the natural log of market value of equity is greater than or equal to the sample median and zero otherwise. Big4 equals one if the company is audited by a Big 4 public accounting firm and zero otherwise. MTB is the natural log of the market value divided by the book value of equity. Leverage is long-term debt divided by total assets. HighAbsAccr equals one if the firm’s level of absolute abnormal accruals is greater than or equal to the sample median and zero otherwise. HighFeeBurden equals one if audit fees divided by total operating expenses is greater than or equal to the sample median and zero otherwise. InstOwn is the percentage of institutional ownership in the company. Industry Controls are created based on the Fama-French 12 industry classification. ................
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