No. 129 January 2014

HHL Working Paper

Differences in Auditing Practices

A Comparative Study of Audit Tenure Effects on Audit Quality Between Germany and the United States

Patrick Kraußa, Benedikt Quosigkb, Henning Zülchc

a Patrick Krauß is a Research Associate at the Chair of Accounting and Auditing at HHL Leipzig

Graduate School of Management, Leipzig, Germany. Email: patrick.krauss@hhl.de

b Benedikt Quosigk is an Assistant Professor at Kennesaw State University Coles College of

Business, Kennesaw, USA. Email: bquosigk@kennesaw.edu c Prof. Dr. Henning Zülch is the Holder of the Chair of Accounting and Auditing at HHL Leipzig

Graduate School of Management, Leipzig, Germany. Email: henning.zuelch@hhl.de

Abstract:Using a matched sample of 1,806 fi rm-year observations from Germany and the United Sta-

tes over the sample period of 2005 to 2010, this paper examines audit practice differences

between both countries. Our empirical results show qualitative similar results with regard to

audit tenure effects on audit quality in Germany and the United States. The results imply that

the increased process of accounting and audit harmonization worldwide have led to quite

some similarities in auditing practices, respectively audit regulations. However, our empirical

results also imply that beside specifi c audit regulation requirements, the auditing practices

in Germany and the United States still differ signifi cantly. In particular, we are able to detect

generally higher levels of earnings management for German companies than their matched

counterparts from the United States. Our results are robust to a variety of sensitivity tests.

The working paper is a revised version of the HHL Working Paper No. 113.

1

1 Introduction

The purpose of this study is to examine potential differences of audit tenure effects on audit

quality between the audit markets in Germany and the United States. Our study is motivated by

several factors. First, the process of business globalization is accompanied by an attempt to in-

creasingly harmonize accounting and auditing practices (Diaconu et al., 2009). In this context,

the convergence of international accounting standards, in particular International Financial Re-

porting Standards (IFRS) and United States Generally Accepted Accounting Principles (US-

GAAP), has received a great deal of interest from researchers and commentators (e.g., Barth et

al., 2012; Jamal and Tan, 2010; Ball and Davant, 2006; Daske, 2006; Tarca, 2004). In contrast,

the harmonization and differences in auditing practices seem to be underexplored. Nevertheless,

the accounting profession - in particular the International Auditing and Assurance Standards

Board (IAASB) of the International Federation of Accountants (IFAC) - encourages the conver-

gence of national and international auditing practices through high quality standards regarding

auditing, review, assurance, quality control, and other related services (ISAs). Moreover, law-

makers in the United States and the European Commission have identified the issue of audit and

accounting standard harmonization as an important regulatory issue (e.g., 8th

European Directive,

Sarbanes-Oxley-Act).

Second, the regulatory landscape in Germany and the United States provides an adequate and

suitable environment for a comparative study on auditing practices. On the one hand, audit regu-

lations in Germany and the United States show considerable similarities with regard to specific

audit requirements (e.g., auditor rotation, audit fee disclosure). Conversely, both countries show

considerable differences in audit regulations (e.g., civil liability for audit failures) and the institu-

tional environment (e.g., investor’s protection, importance of the equity, applied accounting

standards). In our research methodology, we attempt to control for different auditing practices. In

particular, we control for audit quality effects, where the specific audit regulations in the two

countries are quiet similar. In this context, we identified the current audit requirements regarding

audit firm and audit partner rotation in both countries, respectively.

Third, to the best of our knowledge this study is the first to investigate the effects of audit

tenure on audit quality for a comparative sample of firm observations from Germany and the

United States in one comprehensive estimation model. In this context, we choose German firms

to constitute our test sample and matched United States firms as our control sample. The German

audit market is considered the most important audit market of the European Union, while the

United States audit market is considered the most important audit market worldwide. Conse-

2

quently, both audit markets are generally accepted as reference points with respect to auditing

practices and audit regulations, respectively (Quick and Warming-Rasmussen, 2009).

To examine audit tenure effects on audit quality in two countries simultaneously, we proceed

as follows. First, we consider the established earnings management model by Ball and

Shivakumar (2006) in order to calculate the degree of discretionary accruals, hence earnings

management. The estimated discretionary accruals are then utilized as proxies for audit quality in

our model. Second, based on the respective audit data we compute two binary variables in order

to proxy for short-term and long-term auditor tenure. Finally, the association between audit ten-

ure and audit quality is analyzed for both countries in one comprehensive estimation model.

Our empirical results show qualitatively similar audit engagement tenure effects on audit

quality in Germany and the United States. In particular, we are unable to find significant short-

term or long-term audit tenure effects on audit quality in either country. These results imply that

audit engagement tenure is neither in Germany nor in the United States a significant factor with

regard to the quality of the conducted audits. Nevertheless, our empirical results show that the

levels for unsigned and positive signed discretionary accruals are higher in Germany than in the

United States. We assume that the statistically significant differences are mainly attributable to

the less restrictive institutional environment in Germany and the divergent accounting standards

in both countries, namely IFRS and US-GAAP, respectively.

The remainder of this study is structured as follows. Section 2 describes the institutional and

regulatory environment in Germany and the United States. In addition, the section also includes

the theoretical background, linkage to prior literature and hypothesis development. Section 3

contains a description of our empirical research approach and the sample description. In sections

4 and 5, we present the results of our multivariate analysis and the corresponding robustness

checks. Section 6 concludes our paper, recognizes limitations, and suggests future direction.

2 Theoretical Background and Hypothesis Development

2.1 Regulatory Landscape and Institutional Environment

Despite globalization and harmonization of accounting standards, the regulatory landscape in

Germany has maintained certain peculiarities when compared to the institutional environment in

the United States (Quick and Warming-Rasmussen, 2009). First, the German capital market con-

ditions differ from the one existing in the United States. Referring to the study of La Porta et al.

(1997), Germany is characterized by a lower protection of outside investors, a lower importance

of the equity market and a higher shareholder concentration in comparison to the United States.

In another comparative cross-country study La Porta et al. (1998) find that the German institu-

3

tional setting in terms of anti-director rights, efficiency of the judicial system and rule of law is

below average and the standards in the United States, respectively. Overall, the institutional set-

ting in Germany can be classified as less restrictive than the one in the United States.

Second, the civil liability in cases of audit failures differs in Germany and the United States.

If German auditors commit a breach of duties during the audit work, the degree of compensatory

damages is limited by section 323 paragraph 2 of the German Commercial Code (GCC) to 1 mil-

lion € for non-public companies and 4 million € for audits of listed companies. In contrast, the

magnitude of compensatory damages for audit firms in the United States is not limited by specif-

ic regulation. Moreover, audit firms in the United States are exposed to a potential third party

liability as well as class actions. Overall, the civil liability of auditors in Germany is considered

less restrictive than the one in the United States (Quick and Warming-Rasmussen, 2009; Bigus

and Zimmermann, 2008; La Porta et al., 2006).

Third, both countries enacted different accounting standard systems, namely IFRS and US-

GAAP.1 Previous accounting literature has well documented that the two accounting regimes

generally lead to divergent accounting outcomes (e.g., Barth et al., 2012). For example, Callao

and Jarne (2010) provide empirical evidence that earnings management has increased signifi-

cantly after the adoption of IFRS in Europe, indicating that the IFRS accounting system provides

more opportunities to manage earnings than alternative accounting standards (e.g., US-GAAP).

Beside the aforementioned differences in the institutional and regulative setting, the policies

concerning mandatory audit firm and audit partner rotation in Germany and the United States are

quiet similar. With the enactment of the Sarbanes Oxley-Act (SOA) in 2002, law-makers in the

United States limited the audit partner engagement duration to five years for the statutory audit

of a public company. The requirement also includes a five-year cooling off period for the lead

and review audit partner, respectively. Although a more restrictive audit partner rule was imple-

mented by the SOA, the so often discussed mandatory external audit firm rotation requirement

was not implemented by legislators in the United States.

Due to the statutory audit requirements enacted by the European Commission, Germany in-

cluded a key audit partner rotation rule into the GCC by the means of the Accounting Law Re-

form Act in 2004. This legislation requires the mandatory rotation of the lead and review audit

1 The European Commission’s “IAS Regulation” (European Commission, 2002) made IFRS mandatory for the

consolidated financial statements of publicly traded firms from 2005 onwards. The German law-maker adopted

these requirements into the GCC section 315a by the Accounting Law Reform Act in 2004. The act became effec-

tive for fiscal years beginning on or after January 1, 2005. The act contained among other things the rules for the

mandatory IAS/IFRS adoption for listed companies in Germany.

4

partners every seven years with a cooling off period of three years.2 The new requirement be-

came binding for all publicly traded companies for fiscal years beginning on or after January 1,

2007. Neither the SOA nor the GCC contain any requirements concerning the external rotation

of the audit firm.

In summary, the institutional and regulatory environment in Germany differs significantly

from the one in the United States in terms of (1) outside investor’s protection, (2) importance of

the equity market (3) shareholder concentration, (4) anti-director rights, (5) auditor’s liability

regime, and (6) applied accounting regime (IFRS vs. US-GAAP). In contrast to the aforemen-

tioned differences in the regulatory landscape, law-makers in Germany and the United States,

however, implemented qualitatively similar audit partner rotation requirements. In addition, both

countries decided against the implementation of external audit firm rotation requirements. Given

our sample period of 2005 to 2010, the current study is therefore based on comparable auditor

rotation requirements and moreover limited to voluntary audit firm changes in both countries.

2.2 Theoretical Framework

The debate on whether and how auditor tenure affects audit quality has received a great deal of

interest from the audit research profession. Accordingly, current audit literature contains two

competing concepts with regard to audit engagement tenure effects on audit quality, namely the

independence and the expertise hypotheses.3

The independence hypothesis posits that in the first year of an audit engagement, audit quality

is higher than in subsequent periods. In other words, audit quality is negatively associated with

audit firm tenure. Proponents of the independence hypothesis generally argue that the develop-

ment of personal relationships between the audit team and the client’s management may threaten

auditor independence over time and result in lower audit quality (Gold et al., 2012; Azizkhani et

al., 2007). In this context, the IFAC Code of Ethics states that a “familiarity threat occurs when,

by virtue of a close relationship with an assurance client, its directors, officers or employees, a

firm or a member of the assurance team becomes too sympathetic to the client‘s interests”

(IFAC, 2008, p. 18).

In contrast to the independence hypothesis, the expertise hypothesis posits that audit quality is

positively associated with auditor tenure. This theory assumes that growing auditor expertise or

2 The audit partner rotation requirements were adjusted through the Accounting Law Modernization Act in 2009.

The new regulatory requirement reduces the cooling off period for audit partners from three to two years. 3 The terms independence and expertise hypothesis are not mentioned exclusively throughout prior audit tenure

literature. Some studies (e.g., Johnson et al., 2002) merely describe the two competing effects without naming

them independence and expertise hypothesis. Two studies that use these terms exclusively are Gold et al. (2012)

and Azizkhani et al. (2007). The two studies also provide a more detailed discussion of the two opposite concepts.

5

client-specific knowledge outweighs the benefits of short-term auditor independence effects

(Gold et al., 2012; Azizkhani et al., 2007). Prior studies have well documented the importance

and positive effects of client-specific knowledge on audit quality (e.g., Myers et al., 2003; Geiger

and Raghunandan, 2002; Johnson et al., 2002).

2.3 Prior Literature

Several prior studies investigate the association between audit engagement tenure and audit qual-

ity. While the majority of those studies were conducted in the United States, the German audit

market lacks empirical evidence. To synthesize the empirical results of prior audit tenure studies

in either country, we conduct a literature review. For the German audit market the literature fo-

cuses on studies that are conducted after the adoption of IFRS in Germany in 2005. Accordingly,

our review of the audit tenure literature from the United States is based on studies that are pub-

lished after the implementation of the SOA requirements in 2002. Table 1 gives an overview of

the studies in both countries and whether the findings support the independence or the expertise

hypothesis as described in the previous section.4

[Table 1 about here]

In one of the first empirical studies, Quick and Wiemann (2011) analyze German companies

over a sample period of 2005 to 2007. Using signed and unsigned discretionary accruals as a

proxy for audit quality, the authors find a positive association between audit tenure and audit

quality. In another study, Gold et al. (2012) analyze the effects of audit partner and audit firm

tenure on audit quality. The findings with respect to audit firm tenure support the results of the

Quick and Wiemann (2011) study. However, the authors are only able to provide mixed empiri-

cal results on the association between audit partner tenure and audit quality.

In contrast to the limited number of German audit tenure studies, the empirical findings from

the United States audit market provide a more extensive background. As can be seen in Table 1,

the majority of the audit tenure studies from the United States support the expertise hypothesis.

However, some recent audit studies find mixed empirical results (e.g., Davis et al., 2009) or even

provide empirical evidence supporting the independence hypothesis (e.g., Li, 2010; Jenkins and

Velury, 2008).

2.4 Hypothesis Formulation

Similar to the arguments mentioned in the previous sections and given prior findings, we cannot

predict for either the German or the United States institutional setting whether audit engagement

tenure is associated with audit quality. Consequently, we are unable to predict if the impact of

4 See Pott et al. (2009) for a more detailed literature review of international audit tenure studies.

6

audit engagement tenure on audit quality is significantly different between firm observations

from Germany and firm observations from the United States. Therefore, we test the following

non-directional hypothesis for the full matched sample of firm-observations from Germany and

the United States:

Hypothesis (1): The association between audit engagement tenure and audit quality is not

significantly different between German and United Stated firm-year obser-

vations.

3 Methodology

3.1 Sample

Our sample consists of publicly traded German companies performance-matched with compara-

ble publicly traded companies from the United States. The German sample consists of firms be-

longing to the major German stock exchange indices DAX, MDAX, SDAX and TecDAX of the

Frankfurt Stock Exchange. The indices include the largest publicly traded German firms with

regard to market capitalization and trading volume. The audit data for the German sample is

mostly hand-collected from firms’ annual reports. The remaining financial and accounting data is

obtained through the Hoppenstedt Database.

We choose our sample period from the mandatory adoption of IFRS in Germany from 2005

onwards. The complete sample entails the fiscal years of 2005 to 2010. In this context, audit firm

tenure is defined as the number of consecutive years a client firm has engaged a particular audit

firm for their financial statement audit. The calculation of auditor tenure starts in the fiscal year

1999 onwards. Based on the recorded audit firm tenure, we compute the two binary variables

SHORT and LONG to proxy for short-term and long-term auditor tenure. The indicator variable

SHORT takes the value of 1 if the auditor is in the first, second, or third year of the audit en-

gagement, and 0 otherwise. Long audit firm tenure is defined as audit engagement tenure of sev-

en years or longer. With respect to our empirical multivariate analysis, audit engagement tenure

of four to six years is considered as medium-term audit tenure, and serves as our benchmark.

Our starting sample of German companies consists of 1,452 firm-year observations. Our sam-

ple is reduced to 903 firm-year observations due to financial service companies (216 firm obser-

vations), missing accounting and financial data (188 firm observations), foreign issuers (133 firm

observations) that are listed on the Frankfurt Stock Exchange, and companies that issued a US-

7

GAAP financial statement in the respective period (12 firm observations)5. Table 2 gives a brief

overview of the German sample composition.

[Table 2 about here]

3.2 Matching

To compare auditing practices in Germany and the United States, we perform a one-to-one

match of our German sample with a sample of approximately 21,000 firm-year observations of

publicly traded companies from the United States. Before we conduct the one-to-one match, all

variables are winsorized at the 1 percent and 99 percent level. The matching procedure is con-

ducted, similar to the performance-size matching advanced in Kothari et al. (2005). As matching

criteria, we utilize the one-digit SIC code to proxy for industry, total assets to proxy for firm

size, and return on assets ratio (ROA) to proxy for firm performance. The data for the matched

United States sample is retrieved via AuditAnalytics as well as the Compustat Database.

3.3 Earnings Management Estimation Model

Consistent with prior audit literature (e.g., Choi et al., 2010; Myers et al., 2003; Johnson et al.,

2002), we use signed and unsigned discretionary accruals as a proxy for earnings management,

and hence audit quality. Based on the arguments of previous audit studies (Choi et al., 2010;

Myers et al., 2003), we assume that discretionary accruals capture audit quality in a more general

manner than alternative audit quality measures (e.g., qualified audit opinions, audit fraud, ac-

counting restatements). Our accrual measures for earnings management are modeled in accord-

ance with the Ball and Shivakumar (2006) estimation model. The model is estimated as follows:

Equation (1): Earnings Management Estimation Model by Ball and Shivakumar

where, for fiscal year t and firm i, εi = discretionary accruals. The dependent and independent

variables used in Equation (1) are defined in the Appendix.

The final accrual measures for our multivariate analysis are estimated as follows. We first

compute Equation (1) for each one-digit SIC code separately. From the estimated discretionary

accruals, we then calculate unsigned discretionary accruals (|DA|) by taking the absolute value of

the calculated discretionary accruals. Further, we subdivide discretionary accruals into positive

discretionary accruals (DA+) and negative discretionary accruals (DA

-) in order to control for

differences between income-increasing and income-decreasing accruals.

5 The excluded German companies used a regulative option to publish a US-GAAP financial statement until 2007

instead of providing an IFRS annual report.

8

3.4 Model for the Association of Audit Tenure Effects and Earnings Man-

agement

To examine the association between country-specific audit tenure effects and audit quality, we

posit Equation (2) linking the degree of signed and unsigned discretionary accruals with our test

variables SHORT, LONG, and GROUP, as well as their multiplicative interaction terms. The

binary variables SHORT and LONG capture the audit tenure effects on earnings management for

the United States audit market, while the multiplicative interaction terms of SHORT*GROUP

and LONG*GROUP capture the audit tenure effects of our German sample firms. For infor-

mation purposes, the binary variable GROUP (Germany = 1; United States = 0) is included in

Equation (2) in order to control for divergent discretionary accrual levels between German and

United States. The variables used in Equation (2) are defined in the Appendix.

Equation (2): Model for the Association between Audit Tenure and Discretionary Accruals

Consistent with previous empirical audit studies, several control variables are added to Equa-

tion (2) in order to increase the explanatory power of the estimation model and to model eco-

nomic reality more closely. Our control variables are BIG4, LNTA, LOSS, LOSSLAG, LEVE,

BTM, ROE, and CFO. We first include the binary variable BIG4 in order to control for audit

firm size effects on audit quality. We expect that large international audit firms, in this case

Big 4 auditors6, provide higher quality audits than small-sized or medium-sized auditors, respec-

tively (Frankel et al., 2002; Francis et al., 1999; Becker et al., 1998; DeAngelo, 1981). LNTA is

a proxy for client firm size. Based on the results of previous audit studies, we expect that LNTA

is negatively associated with our accrual measures (Myers et al., 2003; Johnson et al., 2002). As

other independent control variables, we added LOSS and LOSSLAG to the estimation model in

order to control for divergent earnings management levels between firms that report negative net

income and firms that report positive net income (Choi et al., 2010; Dechow and Dichev, 2002).

In addition to the binary variables LOSS and LOSSLAG, we add the continuous variable LEVE

to Equation (2). Prior audit literature indicates that firms with high debt ratios tend to have more

incentives to manage or manipulate reported earnings (Ashbaugh et al., 2003; Frankel et al.,

2002; Becker et al., 1998). Furthermore, we include BTM, ROE, and CFO in order to capture

firm growth and profitability effects on the degree of discretionary accruals in our multivariate

analysis (Kerstein and Rai, 2007; Carey and Simnett, 2006; Kothari et al., 2005; Frankel et al.,

6 In general Deloitte, Ernst & Young, KPMG, and PricewaterhouseCoopers are classified as Big 4 audit firms.

9

2002; Becker et al., 1998). Finally, we include several industry indicator variables based on one-

digit SIC code along with year indicator variables in order to control for different industry and

year effects in our multivariate analysis.

4 Results

4.1 Sample Description

We winsorize our raw variables at the 1 and 99 percent level to control for outliers that could

have a significant impact on our empirical results. To compare our samples, we convert the ac-

counting values of the German sample to US-dollars.7 The descriptive statistics of our German

sample are reported separately in Table 3. The magnitude of unsigned discretionary accruals is,

on average, 6 percent of lagged total assets. As expected, the mean value of signed discretionary

accruals is close to 0. Moreover, Table 3 shows that the median company has logged total assets

of 14.24, a leverage ratio of 63 percent, a book-to-market ratio of 53 percent, and a return on

equity ratio of 12 percent. We find a considerable difference between the median and mean val-

ues of BTM and ROE, respectively. This implies that our German sample contains a small num-

ber of firms with a high book-to-market ratio and low or negative return on equity.

The binary variables SHORT, LONG, BIG4, LOSS, and LOSSLAG show plausible descrip-

tive statistics. Our sample of German firms contains, on average, 20 percent short-term and

44 percent long-term audit engagements. Further, 18 percent of the firm observations show a

negative net income during the sample period, while approximately three out of four companies

are audited by a Big 4 auditor.

[Table 3 about here]

Table 4 shows the descriptive statistics for the matched United States sample. The descriptive

statistics show that the magnitude of unsigned discretionary accruals is, on average, 5 percent of

lagged total assets. As expected, the mean value of signed discretionary accruals is close to 0.

Due to the matching process (see section 3.2) the values of LNTA are comparable with those

presented in Table 3 for the German sample. Further, Table 4 shows that the median company

has a leverage ratio of 61 percent, a book-to-market ratio of 49 percent, and a return on equity

ratio of 10 percent. The median and mean values of LEVE are not significantly different. In con-

trast and similar to the German sample, we find considerable differences between the median and

mean values of BTM and ROE. The two control variables indicate that the United States sample

7 To convert the German accounting figures into US-dollars, we use the actual Euro-Dollar exchange rate at fiscal

year end. The exchange rates are obtained from the Worldscope Database.

10

contains a small number of firms with a high book-to-market ratio and a low or negative return

on equity ratio.

Table 4 also presents the descriptive statistics for the binary variables SHORT, LONG, BIG4,

LOSS, and LOSSLAG. Overall, the binary variables show plausible descriptive statistics. On

average, the sample contains 21 percent short-term and 38 percent long-term audit engagements.

Further, 21 percent of the sample firms report a negative net income in the sample period, while

86 percent of the companies engaged a Big 4 auditor for the annual financial statement audit.

[Table 4 about here]

4.2 Multivariate Analyses

Table 5 provides the results of our test for differing audit tenure effects on audit quality in Ger-

many and the United States, where |DA|, DA+ and DA

- are used as dependent variables. As ex-

plained previously, we add the variables SHORT, LONG, and GROUP as well as the multiplica-

tive interaction terms of SHORT*GROUP and LONG*GROUP in order to distinguish between

the German and the United States audit market. The regression is based on a seven-year pooled

sample of 903 firm-year observations from Germany and matched 903 firm-year observations

from the United States.

Table 5 shows that neither the coefficients of SHORT and LONG nor the coefficients for the

multiplicative interaction terms SHORT*GROUP and LONG*GROUP are significantly associ-

ated with signed or unsigned discretionary accruals, respectively. With regard to the theoretical

background of previous audit tenure studies, the empirical results imply that the effects attributed

to the expertise hypothesis appear to negate the effects of the independence hypothesis. Hence,

the results support the rejection of our non-directional Hypothesis (1) developed in section 2.4.

Overall, the empirical results suggest that audit tenure effects are neither in Germany nor in the

United States a significant factor with regard to the quality of the conducted audits. However, as

insignificant findings are generally classified as statistically weak, we can only assume that the

identical results in both countries are based on the following two main reasons. First, law-makers

in Germany and the United States enacted qualitatively similar audit firm and audit partner rota-

tion requirements. Second, the audit markets for large listed companies in both countries are

dominated by a limited number of international audit firms (i.e., Big 4 audit firms; Bigus and

Zimmermann, 2008) that use a similar risk-based audit approach, comparable audit technologies,

and are committed the same external audit quality standards (e.g., ISAs). These two develop-

ments among others help curb the potential differences in auditing practices in both countries,

which could lead to the aforementioned empirical findings. Nevertheless, to investigate the po-

11

tential differences in auditing practices between Germany and the United States additional re-

search may be necessary

In contrast to the aforementioned insignificant results, we are able to find a significantly posi-

tive impact of the variable GROUP on |DA| (ƿ = 0.015, p-value < 0.05) and DA+

(ƿ = 0.019,

p-value < 0.05), respectively. Both significant results indicate that the levels for unsigned and

income-increasing discretionary accruals for German companies are higher than for the matched

observations from the United States. We suggest that, the results can be explained by the less

restrictive institutional environment in Germany, which enables companies to manage their earn-

ings more extensively than companies in the United States. In this context, Leuz et al. (2003)

provide empirical evidence that support our findings. Alternatively, the divergent discretionary

accrual levels can be explained by the accounting standards employed in either country, namely

IFRS and US-GAAP. In this context, Callao and Jarne (2010) provide empirical evidence that

support our results. The authors state that IFRS provides more opportunities to manage earnings

US-GAAP.

Besides our variables of interest, Table 5 also shows that 4 out of 8 explanatory variables are

significantly associated with |DA|. Since the results for all three discretionary accrual measures

are qualitatively similar with regard to the statistical significance of the control variables, we

only discuss the results for the |DA|-model. As expected and consistent with prior research (e.g.,

Johnson et al., 2002), LNTA is significantly negatively associated with |DA| (ƿ = -0.012,

p-value < 0.01). In addition, the results for |DA| in the first column imply that financially dis-

tressed companies tend to report higher levels of discretionary accruals than financially healthy

ones. Consequently, the control variables LOSS (ƿ = 0.055, p-value < 0.01), LOSSLAG

(ƿ = 0.010, p-value < 0.10), and LEVE (ƿ = 0.044, p-value < 0.01) are significantly positively

associated with our dependent variable.

[Table 5 about here]

5 Robustness Analyses

We perform a variety of sensitivity analyses in order to examine the robustness of our findings.

First, our sample period from 2005 to 2010 contains several time-specific events (e.g., mandato-

ry IFRS adoption in Germany, economic and financial crisis, etc.) that could affect our empirical

findings. In order to control for such time-specific effects, we re-estimate Equation (2) for each

sample year separately. The results are qualitatively equivalent to the results reported in Table 5,

indicating that our findings are not significantly affected by time-specific events (not tabulated).

12

Second, several prior studies used various discretionary accrual measures as a proxy for audit

quality. To control the robustness of our results with regard to other discretionary accrual

measures, we re-estimate Equation (2) with an alternative dependent discretionary accrual varia-

ble. We use the widely accepted modified Jones model (Dechow et al., 1995) to calculate new

values for signed and unsigned discretionary accruals, respectively. Table 6 shows the empirical

results for this additional robustness check. Consistent with our original analysis, we neither find

audit tenure effects on audit quality for the German nor the United States sample. In addition and

also consistent with the findings of our main analysis, we are able to detect significantly higher

levels of discretionary accruals for German companies when compared to firms from the United

States. In particular, the coefficient of GROUP is significantly positively associated with |DA|

(ƿ = 0.016, p-value < 0.05) and DA+ (ƿ = 0.034, p-value < 0.05). Differing from the original mul-

tivariate analysis results, we find a statistically negative association (ƿ = -0.012, p-value < 0.10)

between long-term audit tenure (LONG) and income-decreasing discretionary accruals (DA-) for

our United States sample. Nevertheless, this divergent statistically significant coefficient does

neither considerably affect the robustness of our original empirical results nor change our overall

conclusions.

[Table 6 about here]

Third, to test if our empirical results are also robust to alternative audit tenure definitions, we

re-estimate Equation (2) with several alternative specifications for short-term (SHORT) and

long-term (LONG) audit tenure. The results of these additional robustness analyses are qualita-

tively similar to our original empirical findings and therefore do not change our overall study

conclusion (not tabulated).

6 Conclusion and Limitations

In this study, we analyze the empirical association between audit engagement tenure and audit

quality for a comparative sample of firm observations from Germany and the United States. Us-

ing a matched sample of 1,806 firm-year observations from both countries for the sample period

from 2005 to 2010, our empirical results demonstrate that audit engagement tenure is neither in

Germany nor in the United States a significant factor with regard to audit quality. We assume

that the non-divergent and statistically insignificant results are primarily attributable to qualita-

tively similar audit firm and audit partner rotation requirements in both countries. Furthermore,

the empirical results could also be impacted by the dominance of a limited number of worldwide

operating audit firms (i.e., Big 4 auditors), which use similar risk-based audit approaches, com-

13

parable audit technologies and are committed to the same external audit quality standards such as

the ISAs.

In contrast to the aforementioned insignificant results, we find statistically significant results

with regard to higher levels for unsigned and income-increasing discretionary accruals for Ger-

man firms in comparison to matched firms from the United States. In accordance with prior re-

search (e.g., Leuz et al., 2003; La Porta et al., 1997), we assume that the less restrictive institu-

tional environment in Germany enables companies to manage earnings more extensively than

companies in the United States. In addition, the employed accounting standards in both countries

(i.e., IFRS and US-GAAP) play a significant role in this context.

Nevertheless, our results should be interpreted cautiously as our study is subject to several

limitations, which highlight opportunities for future research. First, our methodology assumes

that discretionary accruals are an appropriate measure for earnings management, and hence audit

quality. In this context, prior audit research suggests that accrual measures can be noisy proxies

for earnings management and lead to biased empirical results (e.g., Gul et al., 2009). Future re-

search studies could overcome this limitation by using alternative audit quality measures (e.g.,

qualified going-concern opinions).

Second, our research is based on a voluntary audit firm rotation regime in Germany and the

United States. Under a voluntary auditor rotation regime the observed audit tenure effects on

audit quality can be endogenous, because the auditor change decision is generally based on an

endogenous decision by the client firms’ management. Therefore, we have to point out that our

empirical results are not one-to-one transferable to a mandatory audit firm rotation regime as, for

example, suggested by the European Commission in 2011 (EU-Commission, 2011).

Finally, our audit tenure variables are calculated using published audit reports from fiscal

years 1999 onwards. Therefore, the maximum audit engagement length in our sample is limited

to 13 years. Prior empirical audit studies (e.g., Quick and Wiemann, 2011; Myers et al., 2003)

used a more extensive audit engagement timeframe in order to calculate audit tenure variables. In

this context, we are unable to specify the potential impact of the limited audit tenure timeframe

on our empirical results. However, this limitation is only relevant for the specification of long-

term audit tenure, while the calculation of short and medium-term audit tenure is not affected.

14

Appendix: Definition of Variables The table below summarizes the variables used in the Equations (1) and (2).

Variable Definition Type

BIG4 binary variable equal to 1 if auditor is a Big4 audit firm (Deloitte, PWC, Ernst & Young, KPMG), and 0 otherwise. Binary

BTM total equity divded by market capitalization, book-to-market ratio. Continuous

CFO cash flow from operations scaled by lagged total assets. Continuous

DA signed discretionary accruals estimated in Equation (1). Continuous

|DA| unsigned discretionary accruals estimated in Equation (1). Continuous

DA- negative signed discretionary accruals estimated in Equation (1). Continuous

DA+ positive signed discretionary accruals estimated in Equation (1). Continuous

DCFO binary variable equal to 1 if cash flow form operations is negative, and 0 otherwise. Binary

GROUP binary variable equal to 1 if company is from Germany, and 0 for comanies from the United States. Binary

LEVE total liabilities divided by total assets, leverage ratio. Continuous

LNTA natural log of total assets. Continuous

LOSS binary variable equal to 1 if net income is negative in the current fiscal year, and 0 otherwise. Binary

LOSSLAG binary variable equal to 1 if net income is negative in the prior fiscal year, and 0 otherwise. Binary

PPE total net value of property, plant, and equipment. Continuous

REC total receivables. Continuous

REV total revenue. Continuous

ROE net income divided by total equity, return on equity. Continuous

TA total assets. Continuous

TACC net income minus cash flow from operations, total accruals. Continuous

SHORT binary variable equal to 1 if the auditor is in the first, seconde or third year of the audit engagement, and 0 otherwise. Binary

LONG binary variable equal to 1 if the auditor is in the seventh or later year of the audit engagement, and 0 otherwise. Binary

15

References

Ashbaugh, H./ LaFond, R. and Mayhew, B.W. (2003), Do nonaudit services compromise auditor

independence? Further evidence, The Accounting Review, Vol. 78, Issue 3, pp. 611-639.

Azizkhani, M./ Monroe, G.S. and Shailer, G. (2007), Auditor tenure and perceived credibility of

financial reporting, Working paper, Australian National University.

Ball, R. and Davant, D. (2006), International Financial Reporting Standards (IFRS): Pros and

cons for investors, Accounting and Business Research, Issue 37, pp. 5-27.

Ball, R. and Shivakumar, L. (2006), The role of accruals in asymmetrically timely gain and loss

recognition, Journal of Accounting Research, Vol. 44, Issue 2, pp. 207-241.

Barth, M.E./ Landsman, W.R./ Lang, H.L. and Williams C.D. (2012), Are IFRS-based and US-

GAAP based accounting amounts comparable?, Journal of Accounting & Economics,

Vol. 54, Issue 1, pp. 68-93.

Becker, C./ DeFond, M./ Jiambalvo, J. and Subramanyam, K. (1998), The effect of audit quality

on earnings management, Contemporary Accounting Research, Vol. 15, Issue 1, pp. 1-24.

Bigus, J. and Zimmermann, R.C. (2008), Non-audit fees, market leaders and concentration in the

German audit market: A descriptive analysis, International Journal of Auditing, Vol. 12, Is-

sue 3, pp. 159-179.

Callao, S. and Jarne, J.I. (2010), Have IFRS affected earnings management in the European Un-

ion?, Accounting in Europe, Vol. 7, Issue 1, pp. 159-189.

Carey, P. and Simnett, R. (2006), Audit partner tenure and audit quality, The Accounting Re-

view, Vol. 81, Issue 3, pp. 653-676.

Choi, J.H./ Kim, J.B. and Zang, Y. (2010), Do abnormally high audit fees impair audit quality?,

Auditing: A Journal of Practice and Theory, Vol. 29, Issue 2, pp. 115-140.

Daske, H. (2006), Economic benefits of adopting IFRS or US-GAAP - Have the expected cost of

equity capital really decreased?, Journal of Business Finance and Accounting, Vol. 33, Is-

sue 3-4, pp. 329-373.

Davis, L.R./ Soo, B.S. and Trompeter, G.M. (2009), Auditor tenure and the ability to meet or

beat earnings forecasts, Contemporary Accounting Research, Vol. 26, Issue 2, pp. 517-548.

DeAngelo, L.E. (1981), Auditor size and audit quality, Journal of Accounting and Economics,

Vol. 3, Issue 3, pp. 183-199.

Dechow, P. and Dichev, I. (2002), The quality of accruals and earnings, The Accounting Re-

view, Vol. 77, Supplement, pp. 35-59.

Dechow, P.M./ Sloan, R.G. and Sweeney, A.P. (1995), Detecting earnings management, The

Accounting Review, Vol. 70, Issue 2, pp. 193-225.

Diaconu, P./ Coman, N./ Dobroteanu, C.L./ Dobroteanu, L. and Minu, M. (2009), Harmonization

in auditing profession, Journal of Modern Accounting and Auditing, Vol. 5, Issue 5,

pp. 30-41.

European Commission (2002), Commission recommendation of 16 May 2002 - Statutory audi-

tors' independence in the EU: A set of fundamental principles, Official Journal of the Europe-

an Communities, L 191/122-L191/157.

16

European Commission (2011), Proposal for a regulation of the European Parliament and the

Council on specific requirements regarding statutory audit of public-interest entities, Brussels.

Available from:

http://ec.europa.eu/internal_market/auditing/reform/index_en.htm.

Francis, J.R./ Maydew, E.L. and Sparks, H.C. (1999), The role of big 6 auditors in the credible

reporting of accruals, Auditing: A Journal of Practice and Theory, Vol. 18, Issue 2,

pp. 17-34.

Frankel, R./ Johnson, M. and Nelson, K. (2002), The relation between auditors’ fees for non-

audit services and earnings quality, The Accounting Review, Vol. 77, Supplement,

pp. 71-105.

Geiger, M.A. and Raghunandan, K. (2002), Auditor tenure and audit reporting failures, Auditing:

A Journal of Practice and Theory, Vol. 21, Issue 1, pp. 67-80.

Gold, A./ Molls, F./ Pott, C. and Watrin, C. (2012), The effect of engagement and review partner

tenure and rotation on audit quality: Evidence from Germany, Working Paper, University of

Amsterdam and Muenster.

Gul, F.A./ Jaggi, B.L. and Krishnan, G.V. (2009), Auditor independence: Evidence on the joint

effects of auditor tenure and nonaudit fees, Auditing: A Journal of Practice and Theory,

Vol. 26, Issue 20, pp. 117-142.

International Federation of Accountants (IFAC; 2008), Code of ethics for professional account-

ants, IFAC Ethics Committee Report, pp. 1-98.

Jamal, K. and Tan, H.T. (2010), Joint effects of principles-based versus rules-based standards

and auditor type in constraining financial managers’ aggressive reporting, The Accounting

Review, Vol. 85, Issue 4, pp. 1325-1346.

Jenkins, D.S. and Velury, U. (2008), Does auditor tenure influence the reporting of conservative

earnings?, Journal of Accounting and Public Policy, Vol. 27, Issue 2, pp. 115-132.

Johnson, V.E./ Khurana, I.K. and Reynolds, J.K. (2002), Audit-firm tenure and the quality of

financial reports, Contemporary Accounting Research, Vol. 19, Issue 4, pp. 636-660.

Kerstein, J. and Rai, A. (2007), Intra-year shifts in the earnings distribution and their implica-

tions for earnings management, Journal of Accounting and Economics, Vol. 44, Issue 3,

pp. 399-410.

Kothari, S.P./ Leone, A.J. and Wasley, C. E. (2005), Performance matched discretionary accrual

measures, Journal of Accounting and Economics, Vol. 39, Issue 1, pp. 163-197.

La Porta, R./ Lopez-de-Silanes, F. and Schleifer, A. (2006), What works in security laws? The

Journal of Finance, Vol. 61, Issue 1, pp. 1-32.

La Porta, R./ Lopez-de-Silanes, F./ Schleifer, A. and Vishny R. (1997), Legal determinants of

external finance, The Journal of Finance, Vol. 52, Issue 3, pp. 1131-1150.

La Porta, R./ Lopez-de-Silanes, F./ Schleifer, A. and Vishny R. (1998), Law and finance, Journal

of Political Economy, Vol. 106, Issue 6, pp. 1113-1155.

Leuz, C./ Nanda, D. and Wysocki, P. (2003), Earnings management and investor protection: An

international comparison, Journal of financial economics, Vol. 69, Issue 3, pp. 505-527.

Li, D. (2010), Does auditor tenure affect accounting conservatism? Further evidence, Journal of

Accounting and Public Policy, Vol. 29, Issue 3, pp. 225-241.

17

Myers J.N./ Myers L.A. and Omer, C.T. (2003), Exploring the term of the auditor-client relation-

ship and the quality of earnings: A case for mandatory auditor rotation?, The Accounting Re-

view, Vol. 78, Issue 3, pp. 779-799.

Pott, C./ Mock, T.J. and Watrin, C. (2009), Review of empirical research on rotation and non-

audit services: Auditor independence in fact vs. appearance, Journal für Betriebswirtschaft,

Vol. 58, Issue 4, pp. 209-239.

Quick, R. and Warming-Rasmussen, B.W. (2009), Auditor independence and the provision of

non-audit services: Perceptions by German investors, International Journal of Auditing,

Vol. 13, Issue 2, pp. 141-162.

Quick, R. and Wiemann, D. (2011), Zum Einfluss der Mandatsdauer des Abschlussprüfers auf

die Prüfungsqualität, Journal of Business Economics, Vol. 81, Issue 9, pp. 915-943.

Sarbanes-Oxley Act (SOA; 2002), One hundred seventh congress of the United States of Ameri-

ca, second session, Washington DC.

Available from: http://www.sec.gov/about/laws/soa2002.pdf.

Tarca, A. (2004), International convergence of accounting practices: Choosing between IAS and

US GAAP, Journal of International Financial Management and Accounting, Vol. 15, Issue 1,

pp. 60-91.

18

Independence Expertise

Germany

Quick and Wiemann (2011) 2005-2007 1,013 Abnormal accruals No Yes

Gold et al. (2012) 1995-2010 2,636 Abnormal accruals No Yes1

United States

Geiger and Raghunandan (2002) 1996-1998 121 Going-concern audit opionions No Yes

Johnson et al. (2002) 1986-1995 821 Abnormal accruals and earnings persistence No Yes

Myers et al. (2003) 1988-2000 41,250 Abnormal accruals and current accruals No Yes

Carcello and Nagy (2004) 1990-2001 68,447 Fraudulent financial reporting No Yes

Gosh and Moon (2005) 1990-2000 38,794 Perceptions of investors and information intermediaries No Yes2

Stanley and DeZoort (2007) 2000-2004 382 Accounting restatements No Yes

Jenkins and Velury (2008) 1980-2004 86,914 Conservatism in reported earnings Yes No

Davis et al. (2009) 1988-2006 23,748 Abnormal accruals

Li (2010) 1983-2004 82,663 Conservatism in reported earnings Yes4

No

2 The autho rs pro vide empirica l evidence tha t inves to r perceptio ns o f earnings quality is po s tive ly as s o cia ted with audit tenure .

Supporting TheoryAudit Quality Measure

1 The autho rs find a negative as s o cia tio n fo r audit firm tenure with uns igned and po s itve s igned dis cre tio nary accruals . Ho wever, with res pect to audit partner tenure the s tudy

pro vides mixed empirica l res ults .

3 The autho rs find tha t c lient firms with s ho rt audit tenure are mo re like ly to repo rt dis crea tio nary accrual leve ls tha t a llo w them to meet o r bear earnings fo recas ts than firms

with medium audit tenure . Ho wever, the empirica l res ults fo r lo ng te rm audit tenure are qualita tive identica l.

4 Lo ng-term audito r–c lient re la tio ns hip impo s es grea ter threa t to audito r independence fo r s maller c lients weakly mo nito red by audito rs than la rger c lients .

Results of empirical studies investigating the effects of audit tenure on audit quality

Table 1

Sample

SizeStudy (by year)

Mixed3

Sample

Period

Original Sample 1,452

./. Financial Service Companies 216

./. Missing Data 188

./. Foreign Issuer 133

./. US-GAAP Financial Statement 12

Total 903

Table 2

Composition of German sample

Cont. Variables 25th

Percent. Mean Median 75th

Percent. Std. Dev.

|DA| 0.013 0.062 0.030 0.074 0.099

DA -0.023 0.008 0.007 0.037 0.117

LNTA 13.021 14.375 14.239 15.329 1.843

LEVE 0.488 0.666 0.627 0.767 0.452

BTM 0.340 0.660 0.529 0.828 0.586

ROE 0.045 0.055 0.115 0.187 0.615

CFO 0.049 0.092 0.084 0.128 0.126

Binary Variables Mean 0 1 Std. Dev.

SHORT 0.202 721 182 0.401

LONG 0.437 508 395 0.496

BIG4 0.780 833 70 0.415

LOSS 0.178 199 704 0.383

LOSSLAG 0.140 777 126 0.347

See the Appendix fo r the definitio n o f variables .

Table 3

Distribution of variables - German sample

19

Cont. Variables 25th

Percent. Mean Median 75th

Percent. Std. Dev.

|DA| 0.010 0.050 0.025 0.056 0.078

DA -0.025 -0.005 0.003 0.026 0.093

LNTA 13.017 14.375 14.239 15.329 1.842

LEVE 0.403 0.624 0.612 0.810 0.340

BTM 0.296 0.688 0.492 0.739 4.839

ROE 0.025 -0.064 0.096 0.159 2.230

CFO 0.045 0.094 0.088 0.142 0.133

Binary Variables Mean 0 1 Std. Dev.

SHORT 0.214 710 193 0.410

LONG 0.384 556 347 0.487

BIG4 0.865 808 95 0.342

LOSS 0.214 122 781 0.410

LOSSLAG 0.193 729 174 0.395

See the Appendix fo r the definitio n o f variables .

Table 4

Distribution of variables - United States sample

Independent variables Coefficient Coefficient Coefficient

Intercept 2.449 0.88 -3.755 -0.94 -5.008 -1.43

GROUP 0.015 2.44 ** 0.019 2.07 ** -0.005 -0.63

SHORT 0.005 0.63 -0.003 -0.27 -0.013 -1.40

LONG 0.005 0.68 -0.005 -0.53 -0.011 -1.34

GROUP*SHORT -0.003 -0.29 0.001 0.07 0.009 0.64

GROUP*LONG -0.007 -0.75 -0.007 -0.53 -0.004 -0.41

BIG4 0.007 1.21 0.000 0.04 -0.018 -2.63 ***

LNTA -0.012 -9.88 *** -0.011 -6.17 *** 0.012 8.47 ***

LOSS 0.055 9.80 *** -0.010 -0.46 -0.081 -14.37 ***

LOSSLAG 0.010 1.68 * 0.014 1.26 -0.012 -2.07 **

LEVE 0.044 8.60 *** 0.040 4.46 *** -0.040 -7.07 ***

BTM 0.000 -0.24 0.000 -0.17 0.000 0.22

ROE 0.001 0.70 0.019 4.92 *** 0.002 1.59

CFO 0.011 0.71 -0.054 -2.14 ** -0.090 -4.42 ***

Year and industry dummies

Adjusted R2

N

See the Appendix fo r the definitio n o f variables . Two -ta iled p-va lues s ignificant a t *** 1% level, ** 5% level, * 10% level.

Included Included Included

16% 8% 38%

1,806 392 432

Table 5

Empirical results on the association between discretionary accruals and audit tenure

|DA| DA+

DA-

t-value t-value t-value

German vs. United States sample

Independent variables Coefficient Coefficient Coefficient

Intercept 0.636 0.21 -8.819 -1.29 -1.940 -0.74

GROUP 0.016 2.26 ** 0.034 2.27 ** -0.004 -0.59

SHORT 0.008 0.96 0.006 0.30 -0.010 -1.51

LONG 0.009 1.16 0.001 0.06 -0.012 -1.87 *

GROUP*SHORT -0.004 -0.31 -0.021 -0.83 0.006 0.60

GROUP*LONG -0.006 -0.58 -0.018 -0.82 -0.002 -0.28

Control variables

Year and industry dummies

Adjusted R2

N

Table 6

Robustness analysis on the association between discretionary accruals and audit tenure

Alternative Discretionary Accrual Measure

|DA| DA+

DA-

t-value t-value t-value

Included Included Included

See the Appendix fo r the definitio n o f variables . Two -ta iled p-va lues s ignificant a t *** 1% level, ** 5% level, * 10% level.

Included Included Included

18% 16% 48%

1,806 583 1,223

ISSN 1864-4562 (Online version)© HHL Leipzig Graduate School of Management, 2014The sole responsibility for the content of the HHL Working Paper lies with the author/s. We encourage the use of the material for teaching or research purposes with reference to the source. The reproduction, copying and distribution of the paper for non-commercial purposes is permitted on condition that the source is clearly indicated. Any commercial use of the docu-ment or parts of its content requires the written consent of the author/s.For further HHL publications see www.hhl.de/publications