Accounting Horizons

Vol. 19, No. 2

June 2005
pp. 5168

Mandatory Audit Firm Turnover,

Financial Reporting Quality,
and Client Bargaining Power:
The Case of Arthur Andersen
Albert L. Nagy
SYNOPSIS: This paper examines the effect of mandatory auditor change on audit
quality in the unique environment created by the failure of Arthur Andersen (AA). The
failure of AA forced a significant number of companies (ex-AA clients) to change auditors and also helped increase the overall skepticism exhibited on external audits. The
demise of AA does not truly replicate a mandatory rotation regime, but it does provide
a rich setting to examine one aspect of such a regimethe effect that a forced auditor
change has on the level of audit quality. Furthermore, because ex-AA clients were
forced to change auditors on a one-time basis and will not necessarily have to change
auditors in the future, client bargaining power is likely to influence auditor behavior and
is considered in this studys empirical analyses. This study provides evidence that, for
smaller companies, the level of audit quality improved for companies forced to switch
from AA, and that the negative relation between short auditor tenure and audit quality
was effectively mitigated over the period of AAs demise. The lack of results for larger
companies could reflect higher bargaining power toward their auditor. Further research
is needed to determine if a forced auditor change would improve audit quality for larger
companies in a true mandatory auditor rotation regime, where the amount of bargaining
power possessed by companies would seemingly diminish.
Data Availability: The data are from public sources and are available from the author
upon written request.

INTRODUCTION
he recent financial reporting failures have led to a heightened focus on the work of
external auditors. As a result, certain parties have called for mandatory audit firm
rotation (Clapman 2003; Commission on Public Trust and Private Enterprise 2003;
Imhoff 2003; Silvers 2003). Proponents of mandatory audit firm rotation argue that a new
auditor would bring to bear greater skepticism and a fresh perspective that may be lacking

Albert L. Nagy is an Associate Professor at John Carroll University.

The paper has benefited substantially from the comments of two anonymous referees and from the comments and
advice of Bob Lipe (editor). I also acknowledge the helpful comments and suggestions of Joe Carcello on earlier
versions of this manuscript. Last, I thank the Wasmer Research Fund at John Carroll University for financial
support.

Submitted: August 2004

Accepted: January 2005
Corresponding author: Albert L. Nagy
Email: alnagy@jcu.edu

51

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Nagy

in long-standing auditor-client relationships. Also, when a company has been a client of an

audit firm for a number of years, the client can be viewed as a source of a perpetual annuity,
potentially impairing the auditors independence. Conversely, opponents of mandatory firm
rotation argue that audit quality would suffer under such a regime because the auditor would
lack familiarity with the client and its industry (AICPA 1992; Hills 2002; BDO Seidman
LLP 2003). Furthermore, opponents of mandatory rotation point to a higher incidence of
problem audits in the early years of the auditor-client relationship than when that relationship has extended for a longer period of time (St. Pierre and Anderson 1984; OMalley
2002).
The U.S. Congress appears to have straddled these divergent perspectives. Although
the recently enacted Sarbanes-Oxley Act (2002) does not require mandatory audit firm
rotation, the Act did call for the U.S. Comptroller General to study the potential effects of
mandatory firm rotation. The General Accounting Office (GAO) recently released its study
of mandatory audit firm rotation and concludes that mandatory audit firm rotation may
not be the most efficient way to strengthen auditor independence (GAO 2003, Highlights).
However, the GAO leaves open the possibility of revisiting the mandatory audit firm rotation
requirement if the other Sarbanes-Oxley Acts requirements do not lead to improved audit
quality (GAO 2003, 5). Additionally, several parties including the GAO (2003, 9), New
York Stock Exchange (2003, 11), the Commission on Public Trust and Private Enterprise
(2003, 33), and TIAA-CREF (2004, 9) suggest that periodically changing the audit firm
may enhance audit quality. Therefore, although mandatory rotation is not required at the
present time, regulators, policy makers, and institutional investors continue to be interested
in this topic.
The renewed regulatory interest in mandatory firm rotation has sparked a renewed
academic interest in this area. Since the effects of mandatory firm rotation cannot be studied
using U.S. archival data, the academic studies to date examine the relation between audit
quality (defined using a number of different metrics) and audit firm tenure. Overall, these
studies suggest that long auditor tenure is not associated with a decline in audit quality,
but audit quality is lower in the early years of the auditor-client relationship (e.g., Geiger
and Raghunandan 2002; Johnson et al. 2002; Carcello and Nagy 2004b; Ghosh and Moon
2003; Myers et al. 2003). However, none of these studies can directly assess the possible
effect of mandatory auditor rotation because all of these studies are conducted in a voluntary
auditor change environment.1
This paper contributes to the existing research by studying a forced auditor change
setting (versus a voluntary auditor change setting) that allows for a more direct examination
of how audit quality is affected by a mandatory auditor change and an increase in auditor
skepticism. The recent failure of Arthur Andersen (AA) forced many companies to change
auditors and also helped increase the overall level of skepticism exhibited on all external
audits. Although ex-AA clients were forced to change auditors, they will not necessarily
have to change auditors in the future, thus the post-AA environment is not a true replication
of a mandatory auditor change regime.2 As a result, the events analyzed in this study are
not fully representative of a mandatory rotation environment, but they do allow me to

Johnson et al. (2002) and Myers et al. (2003) attempt to mitigate the problems of potentially opportunistic
switching behavior, which can characterize a voluntary auditor change environment, by excluding first-year
switchers or by excluding companies that did not retain their auditor for at least five years.
Another difference between the situation with ex-AA clients and a mandatory auditor rotation requirement is
that not all of a firms clients would have to be rotated each year.

Accounting Horizons, June 2005

Mandatory Audit Firm Turnover, Financial Reporting Quality, and Client Bargaining Power

53

examine the effect that a forced auditor change has on audit quality in ways that are
unachievable with a sample of voluntary changes. Additionally, the failure of AA and the
newly issued Sarbanes-Oxley Act of 2002, along with a renewed interest in the external
audit function by the financial community, has seemingly raised the overall level of skepticism of external auditors. I posit that this increased skepticism will improve the audit
quality of new audit engagements.
I find evidence of a negative relation between discretionary accruals and ex-AA clients,
but only for companies in the lower half of the sample based on size. This result suggests
that a forced auditor change is associated with a decline in discretionary accruals when the
clients are small and have less bargaining power (as measured by size of the client). Additionally, I find evidence that the significant and positive relation between discretionary
accruals and short auditor tenure disappears in the years following the failure of AA, but
again only for companies in the lower of half of the sample. This result suggests that for
small companies, an increase in auditor skepticism alleviates the positive relation between
short auditor tenure and discretionary accruals. In other words, a healthy dose of skepticism
seems to mitigate the auditing hazards associated with new engagements for small companies that have lower levels of bargaining power.
The remainder of this paper is organized as follows. The next section discusses the
background and previous auditor rotation and client bargaining power research. I then
present the research design, including the statistical model and variable measurement. Subsequent sections discuss the sample selection and results. The last section contains a summary and a discussion of the studys limitations.
BACKGROUND
Researchers have attempted to uncover the likely effect on audit quality of a mandatory
rotation regime by examining the relation between audit quality and auditor tenure. Audit
quality is measured by considering auditor reporting prior to bankruptcy (Geiger and
Raghunandan 2002), fraudulent financial reporting (Carcello and Nagy 2004b) and, most
commonly, various accrual-based measures (Johnson et al. 2002; Ghosh and Moon 2003;
Myers et al. 2003).
Geiger and Raghunandan (2002) find that auditors are more likely to issue a clean audit
report prior to a bankruptcy filing in the early years of the auditor-client relationship.
Carcello and Nagy (2004b) find that fraudulent financial reporting is higher in the early
years of the auditor-client relationship (as compared to medium audit tenure), whereas
they find no evidence that fraudulent financial reporting is higher for long auditor tenure
(nine years or longer).
A number of other studies (Johnson et al. 2002; Ghosh and Moon 2003; Myers et al.
2003) examine the relation between various accrual-based measures, as proxies for financial
reporting quality, and auditor tenure. Johnson et al. (2002) find that the absolute value of
unexpected accruals is higher in the early years of the auditor-client relationship (as compared to medium auditor tenure), whereas they find no relation for long tenure relationships (nine years or longer). Similarly, Ghosh and Moon (2003) find that absolute discretionary accruals and the use of large negative special items to manage earnings decline
with auditor tenure. Finally, Myers et al. (2003) find that longer auditor tenure is associated
with higher earnings quality, using absolute discretionary accruals and absolute current
accruals to proxy for earnings quality. A limitation of these studies, recognized by most of
these authors (e.g., Geiger and Raghunandan 2002, 75; Johnson et al. 2002, 655; Myers et
al. 2003, 21), is that their results from a voluntary auditor change environment may not
Accounting Horizons, June 2005

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Nagy

extend to a mandatory auditor change environment if such a requirement was imposed on

U.S. public companies.
In a mandatory rotation regime, a new auditor may bring greater skepticism to the
audit. Also, the auditor would not view the client as a source of a perpetual annuity. A new
auditor could conceivably bring greater skepticism to the audit, whether the new auditor
was hired after a voluntary change, as a result of the failure of AA, or as a result of a
mandatory rotation requirement. However, I view a companys need to change auditors as
fundamentally different from a companys desire to change auditors. By making a voluntary
auditor change, the company can:

seek an accounting firm whose views on accounting and reporting matters are more
consonant with those of the company;
seek an accounting firm that the company views as more pliable; and
signal that the company is willing to change auditors in the future.

All of these conditions suggest that an auditor may act differently for a company that
voluntarily changed auditors than for a company forced to change auditors. I posit that the
AA auditor changes (versus voluntary auditor changes) more closely resemble auditor
changes of a mandatory rotation regime. Unlike a mandatory auditor rotation regime, however, companies involved in both voluntary and forced (from AA) changes are not required
to change auditors in the future, and thus they may still possess bargaining power toward
the successor auditors. Client bargaining power effects are considered in this studys analysis and are discussed in the next section.
Based on the above discussion, the higher level of skepticism associated with a forced
auditor change (versus a voluntary auditor change) is expected to increase the level of audit
quality. However, the successor auditor of a forced auditor change is still confronted with
the unfamiliarity and the learning curve of a new engagement. Therefore, it is unclear if
the increase in skepticism would overcome the hazards of a new engagement, and thus I
offer no prediction on the overall effect of a forced auditor change on audit quality. I do
expect that, because of the increase in skepticism, changing from AA to another auditor
will improve audit quality to a greater degree than voluntary auditor changes.
In addition to examining the relation between ex-AA companies and discretionary accruals, this paper also studies the impact of an increased level of skepticism on the level
of audit quality level for all new engagements. In an unpublished study, Balsam (2004)
finds that discretionary accruals are lower for years after the AA demise than they were in
prior years. The study also finds that ex-AA clients that remained with a Big 4 auditor
after AAs demise had even lower discretionary accruals. Balsams (2004) results suggest
that other auditors, observing consequences to AA, became more vigilant with their clients,
especially ex-AA clients.3 The demise of AA should not affect the level of expertise and
client understanding that auditors bring to new engagements. This paper examines the
influence of increased skepticism on the relation between short auditor tenure and discretionary accruals. I expect that the increase in skepticism will improve the audit quality of
new engagements (i.e., mitigate the negative relation between audit quality and short auditor
tenure).
3

This paper differs from Balsam (2004) by considering the effect that client bargaining power has on the discretionary accruals and ex-AA relation, and by examining the effect of increased skepticism resulting from AAs
demise on audits performed in the early years of an auditors tenure.

Accounting Horizons, June 2005

Mandatory Audit Firm Turnover, Financial Reporting Quality, and Client Bargaining Power

55

Client Bargaining Power

Zhangs (1999) analytical model demonstrates that the quasi-rents earned in audits
undermine an auditors independence, and that the extent of the compromise is an increasing
function of the quasi-rents. Because audit fees increase with client size (Francis and Simon
1987), prior research uses client size measures as proxies for bargaining power. Evidence
shows that the amount of client bargaining power influences auditor behavior. Specifically,
McKeown et al. (1991) find that larger clients are less likely to receive a going-concern
opinion, even after controlling for the effect of client size on the probability of business
failure. Nelson et al. (2002) find that auditors are more likely to waive proposed audit
adjustments for larger clients. Finally, Carcello and Nagy (2004a) find that the negative
relation between auditor industry specialization and financial fraud is weaker for larger
clients.
Under a mandatory rotation regime, the future annuities of a given client would be
restricted to a set number of years, and the smaller annuities would effectively reduce the
amount of client bargaining power. Although ex-AA clients were forced to change auditors,
they will not necessarily have to change auditors in the future. Therefore, client bargaining
power is not diminished in the post-AA environment and is considered in this studys
empirical analyses. I rely on the Casterella et al. (2004) client bargaining power measures
to capture both the absolute size and relative size of client bargaining power. The calculations of these two client bargaining power measures are discussed in the next section.
RESEARCH DESIGN
Numerous studies examine the association between accounting accruals and various
audit quality proxies. That body of work suggests that the amount of discretionary accounting accruals is a reasonable indicator of audit quality. Specifically, discretionary accruals
are associated with the issuance of qualified audit opinions (Bartov et al. 2000), auditor
changes (DeFond and Subramanyam 1998), eventual auditor litigation (Heninger 2001),
and greater auditor conservatism (Francis et al. 1999). Based on prior research, I posit that
the absolute value of discretionary accruals is a reasonable indicator of audit quality.4 The
regression model employed examines the association between both the forced auditor
change (from AA) and the overall AA demise effect (period effect) on discretionary
accruals.
The two measures for client bargaining power are borrowed from Casterella et al.
(2004). In their study, the authors argue that both the absolute and relative size of the client
are important. That is, large clients are more economically important to the auditor simply
because their audit fees are greater (absolute size), and if industry expertise is of value,
then the economic importance of the client is also influenced by the size of the client
relative to the auditors other industry clients (relative size). Consistent with Casterella et
al. (2004), the regression for this study includes a control variable measuring the relative
size of the client, while the absolute size is implicitly tested by estimating the regression
separately for smaller and larger companies.
The following regression equation is estimated for the four-year period surrounding the
demise of AA (20002003) for both the upper and lower halves of the sample:
4

Following prior research that did not have a clear a priori expectation of managements incentives, I use the
absolute value of discretionary accruals (versus directional unexpected accruals) as a proxy for audit quality
(Warfield et al. 1995; Francis et al. 1999; Bartov et al. 2000; Klein 2002; Johnson et al. 2002).

Accounting Horizons, June 2005

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Nagy

ACCRUALS 1ANDERSEN 2SHORT 3LONG 4PD 5SIZE

6AGE 7GROWTH 8CFLOW 9LEV 10POWER
1119 (Variable*PD) 2064INDUSTRY

where:
ACCRUALS absolute value of discretionary accruals, computed using the cross-sectional
version of the modified Jones (1991) model; total accruals are computed
directly from the statement of cash flows (Hribar and Collins 2002);5
ANDERSEN 1 if the auditor in 2000 and 2001 was AA (for 2002 and 2003 this variable
equals 1 if AA was the ex-auditor), else 0;
SHORT 1 if auditor tenure is less than four years and not an AA or ex-AA observation, else 0;6
LONG 1 if auditor tenure is greater than eight years, else 0;
PD 1 for 2002 and 2003 observations, 0 for 2000 and 2001 observations;
SIZE the log of total assets;
AGE the number of years for which total assets is reported in Research Insight
since 1982;
GROWTH change in total assets scaled by prior year total assets;
CFLOW the companys cash flow from operations scaled by prior year total assets;
LEV total liabilities scaled by prior year total assets;
POWER natural log of sales divided by the sum of industry sales for all firms in
the industry audited by the companys auditor;
Variable*PD interaction terms consisting of all the independent variables (except for
PD) multiplied by PD; and
INDUSTRY dummy variables based on two-digit SIC codes (44 industries).
AA was indicted and convicted by the U.S. Department of Justice during the first half
of 2002 (March and June, respectively), and thus 2000 and 2001 (2002 and 2003) are
considered to be the pre-event (post-event) years.7 The regression model was estimated
using data from the sampled years 20002003. Balsams (2004) results suggest that the
demise of AA and subsequent governmental investigation and legal actions led to other
5

Following prior research, I calculated abnormal accruals by estimating the following model by year and twodigit SIC Code:
TA 1 2(REV AR) 3(PPE)
where:
TA
REV
AR
PPE

earnings before extraordinary items minus cash flows from continuing operations;
total sales revenue;
accounts receivable; and
gross property, plant, and equipment.

All variables are scaled by prior year total assets. The residual of the above regression is the abnormal accrual.
All year and SIC code groupings with less than ten observations were deleted from analyses.
I adopt the definition of short and long tenure from previous research (Carcello and Nagy 2004b; Johnson et
al. 2002). A sensitivity analysis using a continuous measure of tenure is performed later in the paper.
A sensitivity test concerning this cutoff is performed later in the paper.

Accounting Horizons, June 2005

Mandatory Audit Firm Turnover, Financial Reporting Quality, and Client Bargaining Power

57

auditors becoming more vigilant (i.e., increased skepticism) with their clients. The PD
variable measures the overall period effect of AAs demise on discretionary accruals. The
interaction term ANDERSEN*PD measures the influence that the forced auditor change for
ex-AA clients has on ACCRUALS. A negative coefficient on this interaction term would
suggest that the forced auditor change is associated with a decline in discretionary accruals
(an increase in audit quality).
Consistent with prior research, I expect a significant and positive SHORT coefficient
(2). The SHORT*PD and LONG*PD interaction terms measure the impact that the period
effect has on the relation between auditor tenure and discretionary accruals. Negative coefficients on these terms would be consistent with a healthy dose of skepticism from the
external auditor mitigating the negative effects that short and long auditor tenures have on
discretionary accruals.
The control variables SIZE, AGE, GROWTH, CFLOW, and LEV are drawn from
Johnson et al. (2002) and Myers et al. (2003). Consistent with prior research, the coefficients
5, 6, and 8 (7, 9) are predicted to be negative (positive). The control variable POWER
is drawn from Casterella et al. (2004) and measures the relative size (bargaining power) of
the client. 10 is expected to be positive. Absolute size of the client is the other bargaining
power measure and is implicitly tested by estimating the above regression separately for
smaller and larger companies. The parameters PERIOD, ANDERSEN*PD, and SHORT*PD
are expected to be less negative for the larger half of the sample due to these companies
possessing greater amounts of client bargaining power.
SAMPLE
The initial sample consists of all firms listed on the Research Insight full coverage and
research files for the years 2000 to 2003 with sufficient data to estimate discretionary
accruals. Consistent with Hribar and Collins (2002), I eliminate firms that have undergone
a merger or acquisition.8 Prior research provides evidence that Big 6 auditors provide higher
quality audits (or are perceived to provide higher quality audits) than those provided by
non-Big 6 auditors (Palmrose 1988; Becker et al. 1998; Francis et al. 1999; Teoh and Wong
1993). In an effort to avoid this potential confound, I eliminate all observations audited by
non-Big 5/Big 4 auditors. Given the fundamentally different operating characteristics associated with financial institutions, I exclude banks and insurance companies from the
analyses (SIC Codes 40004999 and 60006999). Last, I exclude observations in the extreme 1.0 percent of the discretionary accruals distribution to remove outliers.9 After considering the above criteria and the control variables data requirements, the sample consists
of a total of 12,781 observations.
RESULTS
Descriptive Statistics
Table 1 presents descriptive statistics for each of the base variables included in
the regression model. The means and standard deviations are presented by pre-event
(20002001) and post-event (20022003) periods for the full sample and for each of the
8

I follow Hribar and Collins (2002) method of identifying firms with mergers and acquisitions by using footnote
codes appearing in Research Insight.
When the extreme 1.0 percent is winsorized, the results are consistent with those presented. Additionally, when
these observations are included in the sample, the results are generally consistent with those presented. The
minor difference in the test variables is the ex-AA effect (ANDERSEN*PD) becomes slightly less significant for
the smaller sample (two-tailed p-value .054).

Accounting Horizons, June 2005

Variable
ACCRUALS
ANDERSEN
SHORT
LONG
SIZE
AGE
GROWTH
CFLOW
LEV
POWER

20002001
(n 6,901)
0.145
[0.187]
0.199
[0.399]
0.248
[0.432]
0.307
[0.461]
5.264
[2.000]
10.19
[5.469]
0.231
[3.264]
0.017
[0.568]
0.619
[3.504]
0.058
[0.094]

Full Sample
20022003
All Years
(n 5,880) (n 12,781)
0.093
[0.122]
0.167
[0.373]
0.159
[0.365]
0.377
[0.485]
5.485
[2.009]
11.87
[5.763]
0.021
[0.429]
0.030
[0.332]
0.552
[0.917]
0.055
[0.090]

0.121
[0.162]
0.184
[0.388]
0.207
[0.405]
0.339
[0.473]
5.366
[2.007]
10.96
[5.668]
0.135
[2.418]
0.004
[0.475]
0.588
[2.649]
0.057
[0.092]

58

Accounting Horizons, June 2005

TABLE 1
Descriptive Statistics
mean [standard deviation]

20002001
(n 3,450)

Lower Half
20022003
(n 2,940)

All Years
(n 6,390)

20002001
(n 3,451)

Upper Half
20022003
(n 2,940)

All Years
(n 6,391)

0.187*
[0.213]
0.195
[0.397]
0.277*
[0.447]
0.239*
[0.426]
3.692*
[1.098]
9.254*
[5.225]
0.284
[4.455]
0.121*
[0.777]
0.605
[4.943]
0.034*
[0.073]

0.117*
[0.143]
0.154*
[0.361]
0.193*
[0.395]
0.289*
[0.453]
3.899*
[1.125]
10.64*
[5.480]
0.002*
[0.543]
0.036*
[0.448]
0.493*
[1.248]
0.035*
[0.073]

0.155*
[0.187]
0.176*
[0.381]
0.238*
[0.426]
0.262*
[0.440]
3.788*
[1.115]
9.892*
[5.388]
0.154
[3.297]
0.082*
[0.648]
0.554
[3.730]
0.034*
[0.073]

0.103*
[0.145]
0.202
[0.402]
0.220*
[0.414]
0.376*
[0.484]
6.835*
[1.361]
11.12*
[5.548]
0.178
[1.207]
0.086*
[0.142]
0.633
[0.345]
0.081*
[0.107]

0.069*
[0.089]
0.181*
[0.385]
0.124*
[0.330]
0.465*
[0.499]
7.071*
[1.332]
13.10*
[5.777]
0.040*
[0.268]
0.096*
[0.106]
0.610*
[0.345]
0.076*
[0.100]

0.087*
[0.123]
0.192*
[0.394]
0.176*
[0.381]
0.417*
[0.493]
6.944*
[1.353]
12.03*
[5.739]
0.115
[0.908]
0.091*
[0.127]
0.622
[0.345]
0.079*
[0.104]

Nagy

* t-test significant at .01 (or Chi-square test for categorical variables) for a test of difference in lower half versus upper-half sample means.
Variable Definitions:
ACCRUALS absolute value of discretionary accruals, computed using the cross-sectional version of the modified Jones (1991) model;
ANDERSEN 1 if the auditor in 2000 and 2001 was AA (for 2002 and 2003 this variable equals 1 if AA was the ex-auditor), else 0;
SHORT 1 if auditor tenure is less than four years, else 0;
LONG 1 if auditor tenure is greater than eight years, else 0;
SIZE the log of total assets;
AGE the number of years for which total assets is reported in Research Insight since 1982;
GROWTH change in total assets divided by prior year total assets;
CFLOW cash flow from operations divided by prior year total assets;
LEV total liabilities divided by prior year total assets; and
POWER natural log of sales divided by the sum of industry sales for all firms in the industry audited by the companys auditor.

Mandatory Audit Firm Turnover, Financial Reporting Quality, and Client Bargaining Power

59

subsamples (lower and upper halves).10 Univariate comparisons indicate that several means
between the upper and lower subsamples differ significantly. Specifically, the upper half
observations are generally older, have greater levels of cash flows, and longer auditor tenures than the lower half. Furthermore, the upper half has lower levels of discretionary
accruals and more ex-AA clients than that of the lower half. Although not reported, the
ACCRUALS mean declines significantly from the pre-event period (20002001) to the postevent period (20022003) for the full sample, upper half, and lower half. Consistent with
expectations, this decline is greater for the lower half of the sample.
Table 2 presents the correlations among the independent variables for the upper and
lower halves of the sample. The ex-AA clients tend to be older, have higher growth,
and have larger amounts of leverage. For both the upper and lower samples, clients with
short (long) auditor tenure tend to be younger (older), have high (low) growth, lower
(higher) cash flows, and higher levels of debt. Older, more mature companies tend to have
higher cash flows, lower growth, and lower levels of debt. Last, AGE and CFLOW are
positively correlated with POWER, suggesting that older companies with higher levels of
cash flow make up a higher percent of the auditors market share.
Given some relatively high correlations, particularly in the lower half between LEV and
GROWTH (0.906), CFLOW and GROWTH (0.685), and LEV and CFLOW (0.681), I
computed the variance inflation factors (VIFs) to assess the susceptibility of the model to
problems of multicollinearity. Gujarati (1995, 339) suggests that multicollinearity is unlikely
to be problematic if the variance inflation factors are below 10.0. For the regression estimated using the lower half of the sample, the VIF on the GROWTH variable exceeded 10.0.
When excluding GROWTH from this model, all the VIFs of the base variables fall below
10.0 and the reported results remain qualitatively unchanged. None of the other regression
models had a base variable with a VIF exceeding 10.0.
Primary Tests
Table 3 presents the results of the OLS regression model estimated for the full sample
and each of the lower and upper halves.11 For each set of results (full, lower, and upper),
the first column presents the estimated coefficient for the main variable and its related
t-statistic. The second column presents the coefficient of the interaction variable (i.e., the
main variable multiplied by PD) along with its related t-statistic. All three models are highly
significant and have adjusted R2s between 15.14 percent and 20.27 percent.12
The period variable (PD) is negative and significant for all three models, and suggests
that the absolute values of discretionary accruals declined subsequent to AAs failure. The
SHORT variable is positive and significant for both the full and lower-half samples.
The negative and significant SHORT*PD interaction term for both the full and lower-half
samples suggests that the positive relation between SHORT and ACCRUALS is significantly
less after AAs demise. The interaction term ANDERSEN*PD is significant for both the full
and the lower-half samples, but it is not significant for the upper-half sample. This result
suggests that the forced auditor change from AA is associated with decreased discretionary
10

11
12

Consistent with Casterella et al. (2004), the sample is split based on each years log of total asset median (SIZE
median).
The coefficients for each industry are not included in Table 3 in the interest of brevity.
Aiken and West (1991) recommend centering the continuous variables in regressions such as mine. Centered
regressions assess the effects of the dummy variables at the mean of the continuous variables. When I use
centered data, the results are identical as those reported except for the PD variable; while these coefficients are
not as negative, they remain significantly less than zero for the full, lower half, and upper half samples.

Accounting Horizons, June 2005

60

Accounting Horizons, June 2005

TABLE 2
Pearson Correlation Matrices
Upper Half of Sample (n 6,391)
ANDERSEN
ANDERSEN
SHORT
LONG
SIZE
AGE
GROWTH
CFLOW
LEV
POWER

SHORT

LONG

SIZE

1.000
0.175**
0.523**
0.058**
0.058**
0.085**
0.001

1.000
0.284**
0.054**
0.088**
0.099**
0.087**

LONG

SIZE

AGE

GROWTH

CFLOW

LEV

POWER

1.000
0.075**
0.412**
0.050**

0.036**
0.013
0.024
0.047**
0.031*

1.000
0.390**
0.047**
0.336**

0.121**
0.059**
0.098**
0.007

1.000
0.111**

1.000

0.104**
0.055**
0.041**

0.048**

1.000

0.167**
0.053**

0.080**

AGE

GROWTH

CFLOW

0.037**

1.000
0.089**

1.000

Lower Half of Sample (n 6,390)

ANDERSEN
ANDERSEN
SHORT
LONG
SIZE
AGE
GROWTH
CFLOW
LEV
POWER

SHORT

LEV

POWER

1.000
0.087**
0.276**

0.013
0.012
0.025*
0.008
0.026*
0.008

1.000
0.333**
0.050**
0.239**

0.084**
0.087**
0.040**
0.002

1.000
0.020
0.517**
0.024
0.076**
0.013
0.075**

1.000
0.020

0.010
0.235**
0.051**
0.203**

1.000
0.063**

1.000

0.152**
0.027*
0.086**

0.685**

1.000

0.906**
0.014

0.681**

1.000

0.100**

0.001

1.000

**,* Significant at the .01 and .05 levels, respectively.

See Table 1 for variable descriptions.

Nagy

ACCRUALS 1ANDERSEN 2SHORT 3LONG 4PD 5SIZE 6AGE 7GROWTH 8CFLOW 9LEV
10POWER 1119 (Variable*PD) 2064INDUSTRY

Variable

Prediction
(Main Var)

Intercept

none

ANDERSEN

none

SHORT

none

LONG

none

SIZE

AGE

GROWTH

CFLOW

LEV

POWER

Sample Size
Adjusted R2
F-ratio

0.323***
[47.48]
0.012**
[2.41]
0.025***
[5.48]
0.012**
[2.24]
0.104***
[11.27]
0.018***
[17.50]
0.002***
[4.58]
0.009***
[6.75]
0.024***
[4.74]
0.010
[8.24]
0.077
[3.04]

0.018**

[2.30]
0.018**
[2.42]
0.012
[1.53]

0.007***
[4.75]
0.001**
[2.13]
0.001
[0.24]
0.022**
[2.48]
0.020***
[7.06]
0.152***
[5.04]

12,781
18.34%
46.56***

Lower Half
Main
Interaction
Variable
(Var*PD)
0.368***
[25.51]
0.020**
[2.47]
0.039***
[5.44]
0.014
[1.58]
0.093***
[4.58]
0.029***
[9.80]
0.002***
[2.81]
0.002
[0.88]
0.021***
[3.22]
0.004
[2.25]
0.043
[0.86]

0.036***

[2.82]
0.037***
[3.15]
0.010
[0.79]

0.006
[1.50]
0.001
[1.16]
0.024***
[3.66]
0.024**
[2.12]
0.012***
[3.37]
0.236***
[3.77]

Upper Half
Main
Interaction
Variable
(Var*PD)
0.247***
[22.06]
0.004
[0.75]
0.001
[0.16]
0.005
[0.86]
0.081***
[5.17]
0.007***
[4.68]
0.002***
[4.96]
0.027***
[16.38]
0.102***
[7.41]
0.001
[0.05]
0.089
[3.57]

6,390
15.14%
19.09***

*,**,*** Indicate significance at p 0.10, p 0.05, and p 0.01, respectively (based on one-tailed tests where relation is predicted).
See Table 1 for variable descriptions.

0.004

[0.47]
0.005
[0.60]
0.009
[1.11]

0.002
[0.77]
0.001**
[2.01]
0.092***
[10.05]
0.158***
[6.18]
0.025***
[2.82]
0.098***
[3.50]

6,391
20.27%
26.78***

61

Accounting Horizons, June 2005

PD

Full Sample
Main
Interaction
Variable
(Var*PD)

Mandatory Audit Firm Turnover, Financial Reporting Quality, and Client Bargaining Power

TABLE 3
Regression Model
coefficient [t-statistic]

62

Nagy

accruals for smaller companies. The control variables SIZE, AGE, and CFLOW are significant in the predicted direction for all three models. The variable GROWTH is positive and
significant for two of the models, and LEV and POWER are not significant for any of the
models.
The regression results suggest a reduction in the absolute value of discretionary accruals
for smaller companies that were forced to change auditors from AA. This finding lends
some support to an increase in audit quality following a forced auditor change for companies with limited amounts of bargaining power (as measured by the clients absolute
size). Additional results show lower audit quality for short auditor tenure only for the small
clients in the period prior to AAs failure. Interestingly, this significantly negative effect
goes away in the period after AAs failure, possibly due to auditors of small firms becoming
more skeptical. Large clients did not show any incremental association between short-tenure
and audit quality, which is a new and unexpected finding. However, since the lack of an
association is consistent pre- and post-AA demise, further investigation of the link between
short-tenure and size is left to future research.
Additional Analyses
To assess the robustness of the results, I perform four sets of additional analyses. The
first additional analysis compares the different effects of forced auditor changes and voluntary auditor changes on discretionary accruals during the sampled time period. I reran
the regressions including a dummy variable (VOLSW), along with the related interaction
term (VOLSW*PD), that equals 1 if the company changed from one Big 4 auditor to another
Big 4 auditor (excluding changes from AA) from 2001 to 2002. The variable VOLSW
captures voluntary auditor changes from 2001 to 2002 and parallels the period of the forced
auditor changes resulting from AAs demise. Overall, I identify 111 voluntary auditor
changes in the sample during this period. The regression results are presented in Table 4.
Prior research provides evidence that is consistent with auditor changes being precipitated by auditor conservatism (DeFond and Subramanyam 1998; Krishnan 1994). Consistent with prior research, VOLSW is negative and significant for the full and lower-half
samples, and the VOLSW*PD is positive and significant for the lower-half sample. The
VOLSW and VOLSW*PD variables are not significant for the upper-half sample.13 The results on the ANDERSEN and ANDERSEN*PD variables are consistent with those presented
in the main analysis. These findings suggest that, for smaller companies, voluntary auditor
changes are precipitated by auditor conservatism and results in lower audit quality from
the successor auditor. In contrast, for smaller companies, forced auditor changes result in
higher audit quality from the successor auditor. In sum, these results suggest that the effect
of an auditor change on discretionary accruals is dependent upon whether the change is
voluntary or forced, and illuminate the problem of studying mandatory auditor rotation in
a voluntary change regime.
The second additional analysis considers the sensitivity of the results to the period cutoff date. The problems surrounding Enron began surfacing in October 2001 when the
company announced that it was taking a $1.01 billion nonrecurring charge to earnings. AA
was indicted in March 2002, convicted in June 2002, and started losing a significant amount
of clients during this time period. For the main analysis, I consider 12/31/01 to be the
event cut-off date because both the Enron and AA investigations intensified in early 2002
13

This result suggests that large companies with high amounts of bargaining power change auditors for reasons
other than auditor conservatism by the predecessor auditor. An examination for these possible factors is beyond
the scope of this paper and is left for future research.

Accounting Horizons, June 2005

ACCRUALS 1ANDERSEN 2VOLSW 3SHORT 4LONG 5PD 6SIZE 7AGE 8GROWTH 9CFLOW
10LEV 11POWER 1221(Variable*PD) 2266INDUSTRY

Variable

Prediction
(Main Var)

Intercept

none

ANDERSEN

none

VOLSW

none

SHORT

none

LONG

none

SIZE

AGE

GROWTH

CFLOW

LEV

POWER

Sample Size
Adjusted R2
F-ratio

0.322***
[47.28]
0.010*
[1.90]
0.023***
[2.59]
0.030***
[6.06]
0.010*
[1.83]
0.103***
[11.16]
0.018***
[17.55]
0.002***
[3.97]
0.009***
[6.61]
0.023***
[4.72]
0.010
[8.10]
0.077
[3.05]

0.016**

[1.99]
0.020
[1.43]
0.023***
[2.72]
0.010*
[1.26]

0.007***
[4.79]
0.001*
[1.75]
0.001
[0.22]
0.022**
[2.46]
0.020***
[7.00]
0.152***
[5.04]

12,781
18.37%
45.25***

Lower Half
Main
Interaction
Variable
(Var*PD)
0.367***
[25.42]
0.016*
[1.96]
0.039***
[2.76]
0.048***
[6.09]
0.012
[1.17]
0.091***
[4.48]
0.030***
[9.89]
0.002**
[2.20]
0.002
[0.77]
0.021***
[3.17]
0.004
[2.12]
0.043
[0.86]

0.032**

[2.50]
0.044**
[2.00]
0.047***
[3.64]
0.007
[0.50]

6,390
15.21%
18.64***

0.007
[1.54]
0.001
[0.72]
0.024***
[3.71]
0.024**
[2.10]
0.012***
[3.32]
0.238***
[3.80]

Upper Half
Main
Interaction
Variable
(Var*PD)
0.247***
[22.03]
0.004
[0.73]
0.001
[0.04]
0.001
[0.16]
0.005
[0.85]
0.081***
[5.16]
0.007***
[4.68]
0.002***
[4.86]
0.027***
[16.35]
0.102***
[7.40]
0.001
[0.05]
0.089
[3.57]

0.004

[0.46]
0.001

[0.03]
0.005
[0.56]
0.009
[1.10]

0.002
[0.77]
0.001**
[1.99]
0.092***
[10.04]
0.158***
[6.17]
0.024***
[2.82]
0.098***
[3.50]

6,391
20.24%
25.95***
(continued on next page)

63

Accounting Horizons, June 2005

PD

Full Sample
Main
Interaction
Variable
(Var*PD)

Mandatory Audit Firm Turnover, Financial Reporting Quality, and Client Bargaining Power

TABLE 4
Regression Model Including Voluntary Switches
coefficient [t-statistic]

64

Nagy
TABLE 4 (Continued)

*,**, *** Indicate significance at p 0.10, p 0.05, and p 0.01, respectively (one-tailed tests for predicted
relations).
Variables:
ACCRUALS absolute value of discretionary accruals, computed using the cross-sectional version of the
modified Jones (1991) model;
ANDERSEN 1 if the auditor in 2000 and 2001 was AA (for 2002 and 2003 this variable equals 1 if AA was
the ex-auditor), else 0;
VOLSW 1 if auditor changed from 2001 to 2002 (excluding AA changes), else 0;
SHORT 1 if auditor tenure is less than four years, else 0;
LONG 1 if auditor tenure is greater than eight years, else 0;
PD 1 for 2002 and 2003 observations, 0 for 2000 and 2001 observations;
SIZE the log of total assets;
AGE the number of years that total assets is reported in Research Insight since 1982;
GROWTH change in total assets divided by prior year total assets;
CFLOW cash flow from operations divided by prior year total assets;
LEV total liabilities divided by prior year total assets; and
POWER natural log of sales divided by the sum of industry sales for all firms in the industry audited by
the companys auditor.

and AA began losing a significant amount of clients in early 2002.14 Since the event cutoff date is arbitrary, I reran the regressions excluding observations from the period October
2001 to June 2002. When excluding these observations, the results remain consistent with
those presented in Table 3.
The third additional analysis considers the sensitivity of the results to measurement of
the auditor tenure variables. The cut-offs used to construct the auditor tenure variables
SHORT and LONG are arbitrary. I relied on prior research in determining the short and
long auditor tenure cut-offs (Johnson et al. 2002; Carcello and Nagy 2004b). To test the
sensitivity of the results to these arbitrary cut-offs, I reran the Table 3 regressions replacing
the SHORT and LONG variables with a continuous auditor tenure measure, the natural log
of auditor tenure (LNTEN). For the lower-half sample, LNTEN is negative and marginally
significant (p 0.07). The interaction term, LNTEN*PD, is positive and not significant for
both the full and lower-half samples, and the sum of the coefficients LNTEN and
LNTEN*PD is not significantly different from zero for either sample. Consistent with the
reported results, this finding suggests that the auditor tenure and discretionary accruals
relation is mitigated in the period subsequent to the failure of AA for smaller companies.
Also consistent with the reported results, the ANDERSEN*PD coefficient is negative and
significant (p .05) for the lower-half sample.
The last additional analysis considers the possibility that the discretionary accruals
model is misspecified. Previous research shows that discretionary accrual models are misspecified when applied to stratified-random samples of firms (Dechow et al. 1995; Guay et
al. 1996). Kothari et al. (2005) provide evidence that performance matching on return on
assets controls for the effect of performance on measured discretionary accruals and helps
mitigate model-misspecification issues.
Following Kothari et al.s (2005) suggestion, I reran the Table 3 regressions using a
matched sample of observations. I compiled a sample of 4,506 observations by matching
the ex-AA clients with a control group on year, industry, and return on assets (ROA). For
14

Per Research Insight, AA was listed as the auditor for 1,222 companies in 2000; 1,145 companies in 2001; and
72 companies in 2002. Of the 72 companies that had AA as an auditor in 2002, 70 had a fiscal year-end before
June. Thus, AA had effectively ceased auditing public companies by June 2002.

Accounting Horizons, June 2005

Mandatory Audit Firm Turnover, Financial Reporting Quality, and Client Bargaining Power

65

the full sample, some of the test variables are less significant than the results presented in
Table 3. Specifically, the ANDERSEN variable is positive and marginally significant (pvalue .09), and the ANDERSEN*PD variable is no longer significant (p-value .17).
The results for SHORT, SHORT*PD, and PD are consistent with those presented in Table
3 for the full sample. For the lower-half sample, the significance on some of the test
variables are also somewhat weaker than those presented in Table 3. The interaction terms
ANDERSEN*PD and SHORT*PD are significant at the p .05 level and the p .10 level,
respectively. The results for ANDERSEN, SHORT, and PD are consistent with those presented in Table 3 for the lower-half sample. For the upper-half sample, the results are
consistent with those presented in Table 3. Thus, the results of the matched sample analysis
are consistent with the results presented in Table 3, albeit somewhat weaker. In summary,
based on the additional analyses performed, the reported results appear robust.
SUMMARY, IMPLICATIONS, AND LIMITATIONS
Previous research provides evidence that short auditor tenure is associated with lower
quality audits and generally does not support mandatory auditor rotation. However, a limitation of prior research is that it is performed under a voluntary change regime, and the
results may not extend to a mandatory change regime. The failure of AA forced a significant
number of companies (AA clients) to change auditors and also helped increase the overall
skepticism of all external auditors. This event provides a rich setting to examine the effects
that a forced auditor change and an increase in skepticism have on audit quality.
I find a significant decrease in discretionary accruals for ex-AA clients following the
forced change from AA, but only for smaller firms. I fail to find an association between
ex-AA clients and discretionary accruals for larger companies. I also provide evidence of
an overall decline in discretionary accruals following the failure of AA, suggesting an
increase in the overall skepticism exhibited on all external audits. Moreover, for smaller
companies, the significant positive relation between short auditor tenure and discretionary
accruals disappears in the years subsequent to AAs collapse, suggesting the increase in
skepticism mitigates the hazards associated with new audit engagements of small firms.
This result raises the question of whether the findings under a voluntary change regime can
appropriately be extended to a mandatory change setting.
When a company voluntarily changes auditors, the company can seek an auditor whose
views on accounting and reporting matters are more consonant with those of the company.
Such a change in auditor would most likely result in a lower (or the same) level of vigilance
or skepticism exhibited by the external auditor. Thus, the crux of the argument for mandatory auditor rotation (increase in skepticism) is missing in the existing research on auditor
changes. This studys findings of an insignificant relation between short auditor tenure and
discretionary accruals in the years subsequent to AAs failure and a negative association
between ex-AA clients and discretionary accruals for smaller companies provide some
support for mandatory auditor rotation and calls for further research in this area.
This study is subject to several limitations. First, the period under study involves some
spectacular frauds (e.g., Enron and WorldCom) and one of the most significant accounting
reforms (Sarbanes-Oxley Act of 2002) in history. The results documented in this time period
may not extend to a more subdued environment. Second, I am only able to examine two
years after the failure of AA. The actions of the new auditors of ex-AA companies may
be influenced by the negative publicity and the condemnation of AA during this time period.
This raises the question of whether the relation between ex-AA clients and discretionary
accruals results from an increase in skepticism and/or from a negative perception of AA.
The lack of results for larger companies along with finding a decline in discretionary
Accounting Horizons, June 2005

66

Nagy

accruals for all observations suggests the former. Third, Kothari et al. (2005) suggest that
discretionary accrual models may be misspecified due to the likelihood of discretionary accruals being correlated with company performance. Although the results of the
performance-matched sample analysis are consistent with the results presented in Table 3,
the potential for model misspecification continues to exist. Last, although this study more
directly tests the impact of mandatory auditor change, it is performed under a quasimandatory change environment that differs from a true mandatory auditor change environment. For example, unlike a true mandatory rotation environment, all the forced changes
in this studys setting were from one firm (AA) and resulted from an indictment and conviction against that firm. Also, unlike a true mandatory rotation regime, there is no predetermined length of tenure for the auditors succeeding AA. A predetermined tenure period
would limit the expected future annuities from clients and, in turn, would lessen the amounts
of client bargaining power. However, such a restriction may also negate the auditors incentive to provide high-quality audits for the purpose of maintaining the client engagement
into the future. Although data from a mandatory auditor rotation environment is scarce at
the moment, further research is clearly needed on the effect that such an environment would
have on audit quality.

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Accounting Horizons, June 2005