Audit Tenure, Auditor Rotation, and Audit Quality: The Case of Indonesia

Asian Journal of Business and Accounting, 5(1), 2012, 55-74

ISSN 1985-4064

Audit Tenure, Auditor Rotation, and Audit Quality: The Case of Indonesia Sylvia Veronica Siregar*, Fitriany Amarullah, Arie Wibowo and Viska Anggraita Abstract The Indonesian regulators have made it compulsory to rotate the appointments of public accountants every 3 years and the appointment of public accounting firms every 5 years, since the end of 2002. The purpose of this study is to investigate the effects of auditor rotation and audit tenure of the public accountant and the public accounting firm, on audit quality (before and after the implementation of the mandatory auditor regulation). The results do not support that mandatory auditor rotation increases audit quality or that a shorter audit tenure (both partner and firm level) increases audit quality. Regulators may need to consider revising the regulation (i.e. related to maximum years allowed for auditor to audit their client) and/or introduce other regulations to increase audit quality. Keywords: Audit rotation, Audit tenure, Audit quality, Discretionary accrual JEL Classification: M42

1.

Introduction

Many major corporate collapses, such as Enron and WorldCom in the United States, have been attributed to poor audit quality associated with a perceived lack of auditor independence. These alleged “audit failures” were deemed to have occurred because auditors failed to either detect or report material errors/misstatements in the financial statements. Mandatory auditor rotation has frequently been suggested as a means of *

Corresponding author. Sylvia Veronica Siregar is a Lecturer at the Faculty of Economics, Universitas Indonesia, Depok, Indonesia, e-mail: [email protected]. Fitriany Amarullah is a Lecturer at the Faculty of Economics, Universitas Indonesia, Depok, Indonesia, e-mail: [email protected]. Arie Wibowo is postgraduate student at Graduate Program in Accounting, Faculty of Economics, Universitas Indonesia, Depok, Indonesia, email: [email protected]. Viska Anggraita is a Lecturer at the Faculty of Economics, Universitas Indonesia, Depok, Indonesia, e-mail: [email protected] Asian Journal of Business and Accounting, 5(1), 2012

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Sylvia Veronica Siregar, Fitriany Amarullah, Arie Wibowo and Viska Anggraita

strengthening independence and reducing the incidence of audit failure (Catanach & Walker, 1999). There are arguments for and against mandatory auditor rotation. Proponents of auditor rotation argue primarily that rotation can remedy the potential reduction in auditor independence and the related declines in the quality of financial reporting resulting from lengthy auditor-client relationships (Gavious, 2007). In addition to pressures to retain the client, an extended relationship may cause the auditor to become complacent. This could lead to substandard audits and/or auditors tending to agree with client preferences, which result in poor earnings quality (Myers, Myers, & Omer, 2003). Proponents also argue that rotation would bring a “fresh look” at firm’s financial statements which might increase the likelihood that the auditor will be able to detect misstatements and/or challenge questionable accounting practices. It is considered as an effective way of ensuring auditor objectivity and independence, as well as preventing ‘‘opinion shopping” (Crabtree, Brandon, & Maher, 2006; Lu & Sivaramakrishnan, 2009). Lastly, it is suggested that rotation could lead to audit innovations that allow auditors to audit new clients more efficiently (Crabtree et al., 2006). Opponents of auditor rotation (generally led by the accounting profession) argue that mandatory auditor rotation increases audit startup costs and increases audit failure risk. They argue that new auditors must rely more heavily on management estimates and representation in the initial years of an audit engagement (Myers et al., 2003). As auditor tenure increases, the auditor learns more about the client and its business processes, allowing the auditor to reduce reliance on management estimation and representation, resulting in a more effective audit (Crabtree, 2004). In other words, they believe that extended auditorclient relationships actually increase audit quality; the new auditor will not have the benefit of client-specific knowledge of a previous auditor (GAO, 2003). According to Lu & Sivaramakrishnan (2009), this poor knowledge of the new auditor hampers the effectiveness of the audit process and can result in a deadweight loss to society. Management also tends to be opposed to mandatory auditor rotation, because they face the potentially disruptive, time-consuming, and expensive process of selecting new auditors, and familiarising them with the organisation’s operations, procedures, systems, and industry (AICPA, 1992). Auditor rotation can take place at the firm or partner level. Mandatory audit firm rotation is still being debated in most places, but audit partner rotation has been adopted in certain countries. The professional requirements in the U.S. state that the partner in charge of an audit engagement should be replaced at least once every seven years. The Sarbanes-Oxley Act of 2002 further requires audit partner rotation at 56

Asian Journal of Business and Accounting, 5(1), 2012

Audit Tenure, Auditor Rotation, and Audit Quality: The Case of Indonesia

least once every five years. In the UK, audit partner rotation has been a requirement for many years, and in January 2003, the maximum period for rotation of the lead partner was reduced from seven to five years. Requirements for audit partner rotation also have been adopted in the Netherlands and Germany. In Japan, beginning from April 2004, audit partners and reviewing partners were prohibited from being engaged in auditing the same listed company over a period of seven consecutive years (Chen, Lin, & Lin, 2008). Regardless of the debate surrounding audit firm rotation, this audit firm rotation rule was introduced in a few countries (Comunale & Sexton, 2005; Cameran, Di Vincenzo, & Merlotti, 2005). Italy has adopted mandatory audit firm rotation, while Brazil has adopted mandatory audit firm rotation for banks and listed companies. Several Asian countries have adopted mandatory adoption too. South Korea requires mandatory auditor firm rotation for companies listed in KSE (Korean Stock Exchange) or registered with KOSDAQ (Korea Securities Dealers Automated Quotations) every six years (starting in 2006). Exceptions are: 1) foreign-investment companies, which are subsidiaries of foreign parent companies as defined by the laws of that country and which intend to appoint the same auditors as the parent and 2) companies listed on foreign exchange (NYSE, NASDAQ, and London Stock Exchange only). Singapore has adopted a similar requirement for banks from March 2002. The Monetary Authority of Singapore requires that banks incorporated in Singapore should not appoint the same public accounting firm for more than 5 consecutive financial years. This requirement does not apply to foreign banks operating in the country. India also requires mandatory auditor rotation every 4 years for banks, privatised insurance companies, and government companies. Austria, Spain, Canada, Slovakia, and Turkey adopted mandatory audit firm rotation but have since eliminated their requirements. Ireland considered and rejected a policy of mandatory audit firm rotation. Table 1 shows countries in Asia that have adopted mandatory audit firm and partner rotation. In the case of Indonesia, collapses of many companies and banks during the Asian crisis in 1997-1998 have also raised concerns about the poor audit quality associated with a perceived lack of auditor independence. Only a few months after the enactment of the SarbanesOxley Act in July 2002 in the U.S., in September 2002, the Indonesian Finance Minister signed a Decree on Public Accountant Services (Finance Minister Decree No. 423/KMK.06/2002). This decree mandates auditor partner rotation for three years and audit firm rotation for five years. This decree was revised with the PMK No. 17/PMK.01/2008 where restrictions on the provision of services of audit firms was changed to a Asian Journal of Business and Accounting, 5(1), 2012

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maximum of 6 (six) consecutive fiscal years. In 2011 the government issued a Public Accountant Law that gives authority to the Ministry of Finance to determine whether or not to apply the rotation rule. Until now the Ministry of Finance has not issued any new rules regarding the rotation of the public accountant (auditor). Currently the PMK No. 17/PMK.01/2008 still applies; it requires an audit firm rotation every 6 years while audit partner rotation remains at 3 years. Table 1: Countries in Asia that have Adopted Mandatory Audit Firm and Audit Partner Rotations Country

Mandatory audit firm rotation

Mandatory audit partner rotation

Bangladesh

Yes - every 3 years for listed companies

Japan

Yes - every 3 years for listed companies Yes - every 5 years for government state-owned companies No Yes - every 4 years for banks, privatised insurance companies and Government companies Yes - every 6 years for all companies No

Malaysia

No

China

Hongkong India

Indonesia

Pakistan

Yes - every 5 years for listed companies Philliphines No

Yes - every 5 years for all listed companies

Yes - every 5 years for all listed companies Yes - every 4 years for banks, privatised insurance companies and Government companies Yes - every 3 years for all companies Yes - every certain period within 7 years for listed companies Yes - every 5 years for listed companies and public interest entities Yes - every 5 years for listed companies

Yes - every 5 years for listed companies and bank Singapore Yes - every 5 years for local bank Yes - every 5 years for listed companies Srilanka No Yes - every 5 years for listed companies South Korea Yes - every 6 years for KSE listed Yes - every 6 years for KSE listed companies or KOSDAQ companies or KOSDAQ registered except registered except foreignforeign-invested companies and/or listed invested companies and/or listed on foreign exchange on foreign exchange Taiwan No Yes - every 5 years for listed companies Thailand Yes - every 5 years for listed Yes - every 5 years for listed companies companies

This issue has raised many concerns, especially from the accounting profession. They make the same arguments such as those 58



discussed above, but there is no empirical evidence in the Indonesian context to support their arguments. Most studies on audit tenure and auditor rotation are conducted in other countries (e.g. Ghosh & Moon (2005), Nagy (2005), Myers et al. (2003), Geiger & Raghunandan (2002), Johnson, Khurana & Reynolds (2002) in US; Cameran, Livatino, Pecchiari, & Vigano (2002) in Italy; Chi & Huang (2005) in Taiwan; Chung (2004) in Korea). These previous studies provide empirical evidence regarding the efficacy of restricting audit tenure (auditor rotation) in several countries. However, it is uncertain whether such findings are applicable in Indonesia as Indonesia still has poor law enforcement. CLSA Survey conducted in 2010 showed that of the 11 countries surveyed, Indonesia is one of the countries that showed an increase in the application of corporate governance (CLSA, 2010). However, in terms of the total score of corporate governance, Indonesia is one of the countries that has low law enforcement. Lack of strong law enforcement and also low penalties for violations committed by public accountants (World Bank, 2010) mean that auditors in Indonesia have no explicit liability to the company, shareholders, or other investors, and no accounting firm has been sued for substandard work by companies, shareholders, or third parties. These are factors which can lead to failure to achieve objectives of the ruling, so it is important to investigate the effect of audit tenure and auditor rotation in Indonesia. Our study has four contributions. First, we examine the period before mandatory auditor regulation and the period after. Second, we examine the non linear relationship between audit tenure and audit quality, which has rarely been examined in prior studies. Third, we examine the effects of both audit tenure and auditor rotation. Fourth, we provide evidence on audit tenure and auditor rotation, both at partner level and firm level. Most prior studies only investigate either audit firm rotation or audit partner rotation. This study provides useful insights for the regulation of public accountants in Indonesia in order to ensure the independence and competence of public accountants. This study examines the effectiveness of the auditor rotation rule, i.e. Finance Minister Decree No. 423/KMK.06/2002. We believe that the application of this rule raises the cost for public accountants, corporations, and governments. A study by GAO (2003) finds that almost all of the largest public accounting firms and Fortune 1000 publicly traded companies believe that the costs of mandatory audit firm rotation are likely to exceed the benefits. This study finds that the rotation rule does not improve audit quality and that the government (in this case the Ministry of Finance) needs to reconsider whether its decision on mandatory auditor rotation is achieving its purpose(s). Asian Journal of Business and Accounting, 5(1), 2012

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2.

Previous Studies and Hypotheses Development

Audit quality is another important aspect to be considered in evaluating the usefulness of auditor rotation. Audit quality, according to DeAngelo (1981, p.186), is ‘market-assessed joint probability that a given auditor will both (a) discover a breach in the client’s accounting system, and (b) report the breach’. Jackson, Moldrich, & Roebuck (2008) view the quality of audits from actual and perceived quality. Actual quality shows levels of risk of material errors in financial statements that can be reduced by the auditor. Perceived quality indicates the level of confidence of users in financial statements, and the auditor's effectiveness in reducing material misstatement in financial statements prepared by management. In this study, we use earnings quality as a measure of audit quality. Basically, an audit conducted by an external auditor aims to determine whether the numbers in the financial statements are fairly presented and reflect the true state of a firm’s operating results and financial condition. If the audit quality is "poor", then the resulting accounting earning numbers will be less accurate in reflecting the operating results and the financial condition (Chen et al., 2008). Therefore, earnings quality is used as a proxy of audit quality. Earnings consists of two elements: accruals and cash flows. We focus on the accrual component of earnings because the accrual component of earnings is subject to greater uncertainty than is the cash flow component. Accruals are the product of judgments, estimates, and allocations (of cash flow events in other periods), whereas the cash flow component of income is realised (Francis, LaFond, Olsson, & Schipper, 2005). Furthermore, accruals can be divided into discretionary and nondiscretionary accrual components. Non-discretionary accruals are accounting adjustments to the firm's cash flows mandated by accounting standard-setting bodies, while discretionary accruals are adjustments to cash flows selected by the manager in order to affect reported net income (Healy, 1985). Higher discretionary accruals indicates lower earnings quality, hence in this research, audit quality is measured by the level of discretionary accruals. The benefit of using discretionary accruals as a measure of audit quality is that it reflects the auditor’s enforcement of accounting standards (Lawrence, Minutti-Mega, & Zhang, 2011). Some studies also use discretionary accruals (Johnson et al., 2002; Myers et al., 2003; Lawrence, Minutti-Mega, & Zhang, 2011) as a proxy for audit quality. Geiger and Raghunandan (2002) find that there were significantly more audit reporting failures in the earlier years of the auditor-client relationship than when auditors had served these clients for longer tenures. Reporting failure is defined as a case where the 60



bankrupt company did not receive a going-concern modified audit report from their auditor prior to bankruptcy. Their results do not support the arguments of those who propose mandatory auditor rotation and suggest that, contrary to the concerns expressed by the SEC, there is an inverse relationship between auditor tenure and audit reporting failures. Carcello and Nagy (2004) use cited fraudulent financial reporting as a proxy for audit quality. They find that fraudulent financial reporting is more likely to occur in the first three years of audit firm tenure, but they fail to find evidence that fraudulent financial reporting is more likely, given long audit firm tenure. Johnson et al. (2002) investigate the relationship between audit firm tenure and absolute discretionary accruals. They classify audit firm tenure into three categories: short (two to three years), medium (four to eight years), and long (nine or more years). They use the group of medium tenure as a benchmark and find that short tenure is associated with larger absolute discretionary accruals but long tenure is not, which suggest that long audit firm tenures are not associated with a decline in earnings quality. Myers et al. (2003) investigate the relation between audit firm tenure and two measures of accruals: discretionary accruals and current accruals. They find that the magnitude of both measures of accruals declines with longer audit firm tenure. They also find that longer audit firm tenure is associated with both less extreme income-increasing, and less extreme income-decreasing accruals, which suggests that earnings management becomes more limited as audit firm tenure gets longer. Overall, they find no evidence that a longer audit firm tenure is associated with lower earnings quality. Chi and Huang (2005) find that discretionary accruals initially are negatively associated with audit partner tenure and audit firm tenure, but the associations become positive after the tenure exceeds five years. They interpret this result as suggesting lower earnings quality when the auditor is “excessively familiar” with the client. However, the empirical tests in Chi and Huang (2005) do not include absolute discretionary accruals, and do not separate positive and negative discretionary accruals. Chen et al. (2008) report a negative relationship between audit partner tenure and the absolute value of unexpected accruals, from a sample of Taiwanese firms from 1990-2001. Although they conclude that concerns about the effect of audit partner tenure could be misplaced, they do not separately examine instances of positive and negative unexpected accruals (i.e., they treat over and under accruing symmetrically). They also exclude the first year of the incoming partner’s engagement responsibility, despite the fact that the most marked effect of a rotation might be expected to occur at that time. Asian Journal of Business and Accounting, 5(1), 2012

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Additional evidence of Taiwanese audit partner rotation is provided by Chi, Huang, Liao, and Xie (2009). They examine partner rotations occurring under a regime of mandatory rotation introduced from 2004. While they find some results consistent with higher quality auditing for those firms subject to mandatory rotation, this does not hold true when these same firms are used as a control (i.e., when results for 2004 are compared to 2003). However, they do identify a consistent pattern in earnings-response coefficients, which they interpret as evidence of improved auditor independence in appearance, if not in fact. Further evidence of the possible effect of audit firm tenure is provided by Kim, Min, & Yi (2004). They examine the relatively unique setting that prevails in Korea, whereby the securities regulator can appoint a designated auditor to replace the incumbent, so that the auditor is not selected by the client firm, but rather by the regulator. They find that unexpected accruals are lower (i.e., less positive) in years following mandatory auditor rotation. But the authors concede that the mandatory switch to a designated auditor typically follows and/or coincides with significant financial distress, as well as broader corporate governance issues. However, it is also possible that the effects they observe as being associated with mandatory audit firm rotation, reflect the likelihood that such effects are most likely to be observed where the switch of audit firms is not voluntary. Myers et al. (2003), Chi and Huang (2005), and Chen et al. (2008) indicate that longer audit tenure is not associated with a decline in audit quality. However, Vanstraelen (2000) in the Belgium context, Davis, Soo, and Trompeter (2003) in the US context, and Chung (2004) in the Korea context, find inconsistent results. Vanstraelen (2000) finds that long-term auditor-client relationships significantly increases the likelihood of an unqualified opinion. Davis et al. (2003) provide evidence that audit tenure is associated with lower financial-reporting quality, and they suggest that management gains greater reporting flexibility and is able to meet earnings forecasts more easily, as auditor tenure increases. Chung (2004) finds that discretionary accruals by firms that fulfill the rotation requirement decrease after the passage to a mandatory rotation regime. This suggests that audit quality seems to improve when the length of auditor-client relationship is limited. We find several studies related to audit tenure in the Indonesian setting. Mayangsari and Wahyuni (2005) investigate the effects of audit firm tenure on earnings quality and Mayangsari and Sudibyo (2005) investigate the effects of audit tenure on probability of auditor litigation. Both studies find that there is significant and linear relation between audit tenure and earnings quality (probability of auditor litigation). But these studies only use audit firm tenure and do not consider audit 62



partner tenure. Fanny & Siregar (2007) examine both audit firm and audit partner tenure and rotation. They find that audit firm rotation increases discretionary accruals but audit partner rotation does not have significant effects; whereas both audit firm tenure and audit partner tenure are associated with lower discretionary accruals. This study adds to existing literature in Indonesia by examining non-linear relationships between audit partner and audit firm tenure and audit quality. Both proponents and opponents of mandatory rotation have their own arguments with evidence to support them. Proponents of mandatory rotation (Catanach and Walker, 1999; Johnson et al., 2002; Crabtree, 2004; Chen et al., 2008) argue that it will prevent long-term auditor-client relationships that could impair independence and objectivity. Over time, auditor’s incentives shift toward maintaining and profiting from the client and auditors become less concerned with litigation relating to client. Auditors become less objective and apply less effort toward the detection of material misstatements. They propose that mandatory rotation would bring a “fresh look” at firm’s financial statements which might increase the likelihood that the auditor will uncover misstatements and/or challenge questionable accounting practices. Rotation could lead to audit innovations that allow auditors to audit new clients more efficiently. If the tenure period were limited, auditors also would have greater incentives to resist management pressures (AICPA, 1992, 1–2). Finally, supporters of rotation suggest that it would foster a more competitive market. Opponents of auditor rotation argue that mandatory auditor rotation increases audit start-up costs and increases the risk of audit failure because new auditors must rely more heavily on management estimates and representation in the initial years of an audit engagement (Myers et al., 2003). As auditor tenure increases, the auditor learns more about the client and its business processes, allowing the auditor to reduce reliance on management estimation and representation, resulting in a more effective audit (Crabtree, 2004). In addition, new auditors will not have the benefit of client-specific knowledge of a previous auditor (GAO, 2003), and this weakens the effectiveness of the audit process (Lu & Sivaramakrishnan, 2009). Another argument against mandatory rotation (Catanach and Walker, 1999) is that the predecessing auditors will not be able to transfer their knowledge of the client, its accounting system, and market to successors, and this “value is destroyed by rotation”. Managements tend to be opposed to mandatory auditor rotation because they face potentially disruptive, time-consuming, and expensive processes of selecting new auditors, and familiarising them with the organisation’s operations, procedures, systems, and industry (AICPA, 1992). Another concern is that new auditors may not have the Asian Journal of Business and Accounting, 5(1), 2012

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industry expertise or may not possess the same level of firm specific knowledge required to audit a new client effectively (Dunham, 2002). Based on two arguments above, the relationship between audit tenure and audit quality can be depicted as follows: Figure 1: Relationship between Audit Tenure and Audit Quality

From the preceding explanation, we expect there is a non-linear (quadratic and concave) relationship between audit tenure and audit quality. Because we measure audit quality by discretionary accruals, where higher discretionary accruals indicate lower audit quality, we posit that the relationship between auditor tenure and discretionary accruals is quadratic and convex. Hence, we formulate the following hypotheses: H1a: The relationship between audit partner tenure and discretionary accruals is non-linear (quadratic and convex) H1b: The relationship between audit firm tenure and discretionary accruals is non-linear (quadratic and convex) As mentioned above, both proponents and opponents of mandatory auditor rotation have their own arguments with evidence to support them. However, which arguments are valid, is an empirical question. Hence, we make no prediction for the following hypotheses: H2a: H2b:

3.

Audit partner rotation is associated with discretionary accruals Audit firm rotation is associated with discretionary accruals

Research Method

We used the following research model to test above hypotheses:

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ABSDACit

= α0 + α1PTENUREit + αa2 PTENURE2it + α3 FTENUREit + α4FTENURE2it + α5PROTATIONit + α6FROTATIONit + α7SPECit + α8BIG4t + α9LEVit + α10GROWTHit + α11SIZEit + εit

Whereas: DAC

=

PTENURE

=

FTENURE

=

PROTATION

=

FROTATION

=

SPEC

=

BIG4

=

LEV GROWTH SIZE

= = =

absolute discretionary accruals We used the cross sectional Kasznik (1999) model to calculate discretionary accruals: TACCit/TAi,t-1 = α1(1/TAi,t-1) + α2(ΔREVit – ΔRECit)/TAi,t-1 + α3PPEi,t/TAi,t-1 + α3ΔCFOi,t/TAi,t-1 + εit TACCit = total accrual year t, TAit-1 = total asset at the beginning of year t, ΔREVit = change in revenue between year t and t-1, ΔRECit = change in receivables between year t and t-1, PPEit = gross property, plant, and equipment in year t, ΔCFOit = change in cash flows from operation between year t and t-1 the length of time the Audit Partner has been the auditor of a company in a given year (number of years). the length of time the Public Accounting Firm has been the auditor of a company in a given year (number of years). dummy variable, 1 if there is audit partner rotation and 0 otherwise dummy variable, 1 if there is audit firm rotation and 0 otherwise dummy variable, 1 if the company is audited by specialised auditor (have > 10% market share in an industry, based on its client’s total asset) and 0 otherwise. dummy variable, 1 if the company is audited by Big4 and 0 otherwise debt-to-total asset price-to-book value natural logarithm of ending book value of total assets

We use SPEC, BIG4, LEV, GROWTH, and SIZE as control variables. SPEC, BIG4, GROWTH, and SIZE are expected to have Asian Journal of Business and Accounting, 5(1), 2012

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negative relationships with discretionary accruals, whereas LEV is expected to have positive relationships. We used two observation periods in this study: year 1999 – 2001 to represent years before mandatory auditor rotation regulation (KMK No. 423/KMK.06/2002) and year 2004-2008 for years after the mandatory auditor rotation regulation. We excluded years 2002 and 2003, because those were the first years of implementating the regulation.

4.

Results and Discussion

Table 2 presents descriptive statistics for both periods i.e. before and after mandatory auditor rotation regulation. The mean of DAC after mandatory auditor rotation (0.0640) is smaller than periods before (0.1151). Audit tenure, for both audit partners and audit firms, is shorter for the periods after. PTENURE and FTENURE have high standard deviations because of auditor switching for several firms, especially large ones, and in certain industries they are not always easy. They may need specialised auditors and more auditor resources in terms of audit staff force, to audit their financial statements. Hence, this condition makes PTENURE and FTENURE longer in some firms but shorter for other firms, resulting in a high standard deviation. Auditor rotation also increased due to the effect of the regulation. After the implementation of the regulation, fewer firms were audited by the BIG4. This is a consequence of the regulation, which reduced the market share of the Big 4 accounting firms. Regression results for periods before and after the mandatory auditor regulation are presented in Table 3. From regression results in Panel A and Panel B of Table 3, we can see that hypotheses 1a and 1b regarding non linear relationships between auditor tenure (both for audit partner and audit firm) are not supported. AUDIT PARTNER TENURE has a negative significant relationship with discretionary accruals for the period before mandatory auditor rotation regulation, but it has a positive significant relationship for the period after. These findings indicate that before auditor rotation became mandatory, longer audit partner tenure was associated with higher audit quality (lower discretionary accruals), whereas after auditor rotation became mandatory, a longer audit partner tenure became associated with lower audit quality. There is no significant relationship between AUDIT FIRM TENURE and discretionary accruals for the period before auditor mandatory regulation, but there is a positive relationship for the period after. The positive result for audit firm tenure is consistent with audit partner rotation result as well.

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The results for the period after mandatory auditor rotation do not provide support for the current regulation to mandate auditor rotation. Limitation of tenure still results in lower audit quality. Meanwhile, in the period before auditor rotation is mandatory, a longer auditor tenure is associated with higher audit quality. The possible explanation for these results is that the r egulation mandates that after 3 years and 5 years, the audit partner and audit firm should be rotated respectively. As a result, the auditor may not be familiar enough with the client to have firm-specific knowledge to audit the client effectively. This finding is consistent with Carcello and Nagy (2004), who find that fraudulent financial reporting is more likely to occur in the first three years of audit firm tenure. This evidence suggests that the regulator may need to consider changing the mandatory length of auditor tenure. Maybe a longer auditor tenure is needed to provide auditors enough time to obtain knowledge regarding their clients. There is another possible explanation for these findings. There is a positive effect of audit partner tenure and audit firm tenure on discretionary accruals in the period after mandatory auditor regulation. Whereas in the period before mandatory regulation, the effect is negative for audit partner (not significant for audit firm) and may indicate that mandatory limitation on audit tenure may not be warranted. The negative effect of auditor tenure on audit quality only emerged after the regulator enacted the tenure limitation. The results from auditor rotation also support this explanation. Table 3 we can see that for years before mandatory auditor rotation regulation, AUDIT PARTNER ROTATION had negative signs, while AUDIT FIRM ROTATION had positive signs. These indicate that firms which do audit partner rotation have lower discretionary accruals (higher audit quality) than firms without audit partner rotation, but firms which have audit firm rotation have higher discretionary accruals (lower audit quality) than firms without audit firm rotation. In contradiction, there are no significant results for both audit partner and audit firm rotation in the years after the regulation. These results suggest that audit partner rotation has positive effects on audit quality but only in voluntary situations (not mandatory by regulation) and that after auditor regulation is mandated there is no evidence that it has a positive and significant effect on audit quality. If we compare these results with those of audit partner tenure and audit firm tenure, the result is not contradictory. It is possible that although audit firm partner (audit firm) is changed every 3 years (5 years), old and new auditors do not affect the level of discretionary accruals because both do not have sufficient knowledge of their client’s business and risk. The insignificant affect of auditor rotation on audit quality suggests that the existing mandatory Asian Journal of Business and Accounting, 5(1), 2012

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auditor rotation may not be an effective mechanism to increase audit quality. The regulation about rotation in Indonesia has a loophole where firms may seem to have changed their audit firms, but actually this is not the case. The audit firms only change the local name of their audit firms by changing 50% of its audit partners, but their foreign affiliates do not change (e.g., quasi rotation). Afriansyah & Siregar (2007) and Fitriany (2010) find evidence regarding this quasi rotation. Table 2: Descriptive Statistics Panel A: Year 1999 -2001 (Period Before Mandatory Auditor Regulation) Variable DAC PTENURE FTENURE PROTATION FROTATION SPEC BIG4 LEV GROWTH SIZE (in Rp 000.000) N = 559

Minimum 0.0000 1 1 0 0 0 0 0.0300 -2.4600 20,070

Maximum 1.0379 12 12 1 1 1 1 4.6900 4.4000 58,275,211

Mean 0.1151 3.2021 5.1431 0.3560 0.1342 0.5921 0.7853 0.7788 0.9487 1,881,855

Std. Deviation 0.1338 2.7383 3.1024 0.4792 0.3411 0.4919 0.4110 0.5860 1.0986 4,569,463

Panel B: Year 2004 -2008 (Period After Mandatory Auditor Regulation) Variable DAC PTENURE FTENURE PROTATION FROTATION SPEC BIG4 LEV GROWTH SIZE (in Rp 000.000) N = 1,132

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Minimum 0.00001 1 1 0 0 0 0 -0.1798 -2.2000 4,976

Maximum 0.67657 5 9 1 1 1 1 5.1945 4.6200 102,887,052

Mean 0.0640 1.6837 2.2473 0.5035 0.3675 0.4231 0.4417 0.5929 1.1731 3,326,034


Std. Deviation 0.0654 0.7736 1.2744 0.5002 0.4823 0.4943 0.4968 0.4502 1.0821 9,574,922


Table 3:Regression Results Panel A: Year 1999 -2001 (Period Before Mandatory Auditor Regulation) Variable C PTENURE PTENURE2 FTENURE FTENURE2 PROTATION FROTATION SPEC BIG4 LEV GROWTH SIZE Adj R2 F-stat p-value

Expected Sign + + +/+/+ + 0.1688 11.3006 0.0000

Coefficient 0.3950 -0.0287 0.0002 -0.0027 0.0005 -0.0350 0.0386 -0.0212 0.0187 0.0869 -0.0074 -0.0115

t-stat 3.9213 -1.7400 0.4955 -0.9106 0.6347 -1.9233 1.5294 -1.6225 1.0950 8.9787 -1.4488 -3.0265

p-value 0.0001 0.0412 0.3102 0.1814 0.2629 0.0275 0.0634 0.0526 0.1370 0.0000 0.0740 0.0013

*** **

** * * *** * ***

***

Note: *, **, *** denotes significance at the 0.1, 0.05 and 0.01 levels, respectively

Panel B: Year 2004 -2008 (Period After Mandatory Auditor Regulation) Variable C PTENURE PTENURE2 FTENURE FTENURE2 PROTATION FROTATION SPEC BIG4 LEV GROWTH SIZE Adj R2 F-stat p-value

Expectation + + +/+/+ + 0.0801 4.5619 0.0000

Coefficient 0.1869 0.0135 0.0008 0.0073 0.0061 -0.0006 0.0012 0.0017 -0.0088 0.0274 0.0036 -0.0060

t-stat 4.0248 2.3755 0.0625 1.5087 1.2676 -0.4509 0.1993 0.2477 -1.3725 5.0187 1.4217 -3.5587

p-value 0.0001 0.0090 0.4751 0.0661 0.1028 0.6523 0.8421 0.4023 0.0853 0.0000 0.0779 0.0002

*** *** *

* *** * ***

***

Note: *, **, *** indicate significance at the 0.1, 0.05 and 0.01 levels, respectively

LEV and SIZE are the only control variables which have consistent results as predicted. These findings are consistent with the ‘debt covenant’ hypothesis and the ‘political cost’ hypothesis. SPEC only has negative effects on discretionary accruals (positive effect on audit Asian Journal of Business and Accounting, 5(1), 2012

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quality) in the period before the regulation. This may be due to the existence of other new regulations besides mandatory auditor rotation that enhance quality such as the adoption of IFRS convergence, so it will mitigate SPEC’s effect on audit quality. Firms audited by the BIG4 had lower discretionary accruals than firms audited by non Big 4 accounting companies only in the years after the regulation. because in that period a firm had to hire a new public accounting firm after 5 years, and the BIG 4 had better resources, human capital, and quality than the non Big 4 in the first year assignment, despite the familiarity effect. GROWTH, however, had inconsistent results between both periods. This maybe because the proxy we chose (PBV) was not the best proxy for growth. Market value may include such subjective elements as analyst views and speculation and book value may depend on subjective estimation of assets (Kogan & Papanikolaou, 2010). Overall results show evidence more consistent with opponents of the ‘auditor rotation’ arguments. Although there is evidence that longer audit tenure results in lower audit quality for the period after mandataory auditor rotation, this relationship does not hold for the period before mandatory auditor rotation; and the results also show that auditor rotation after the regulation was enacted do not have positive effects on audit quality. These findings suggest that extended auditorclient relationships seems to increase audit quality, which may stem from the fact that as auditor tenure increases, the auditor learns more about their client and the client’s business processes, which results in a more effective audit (Crabtree, 2004). Also, new auditors may not have the industry expertise or may not possess the same level of firm specific knowledge required to audit a new client effectively compared to old auditors (Dunham, 2002).

5.

Conclusion

Our results show that longer audit tenure became associated with lower audit quality for the period after mandataory auditor rotation, but conversely for the period before it became mandatory, longer audit tenure increased audit quality. The results also show that auditor rotation before regulation (voluntary rotation) did increase audit quality, whereas mandatory auditor rotation does not show having positive effects on audit quality. Overall, we do not find strong evidence to support the notion that the existing mandatory auditor rotation is effective to increase audit quality. The conflicting results are probably due to the low law enforcement in Indonesia. Besides, there is a loophole in the rotation regulation that allows audit firms to do quasi rotation. Further research about audit rotations can examine the effect of quasi 70



and rill rotation on audit quality. The evidence suggests that the regulator may need to examine whether the negative effect of auditor tenure on audit quality may become positive if the regulator changes the maximum years allowed for an auditor to audit their clients and/or develops other mechanisms to increase audit quality and also to maintain auditor independency. There are several limitations to this study. First, we only used discretionary accruals as a proxy of audit quality. Further studies may use another proxy for audit quality or use several proxies for audit quality. Second, we have not examined the relationship between audit tenure and auditor rotation on audit quality for each industry. Third, we have not considered corporate governance variables as a variable that may affect the relationship between audit tenure and auditor rotation with audit quality. The results of these findings can be a valuable input for regulators to reconsider the rules of the rotation in Indonesia. The decline in audit quality following the rules of rotation indicates the need for other mechanisms created by the institutions of public accountants Indonesia (IAPI) such as peer review and effective training to improve the competence of auditors. The other implication is the desirability of enriching Indonesia’s literature on the relationship between the auditor rotation, audit tenure, and audit quality in the context of developing countries, and supporting future possible research.

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