The impact of audit rotation on the comparability of financial reports<sup>,</sup>

Sousa, Allison Manoel de; Ribeiro, Alex Mussoi; Vicente, Ernesto Fernando Rodrigues

doi:10.1590/1808-057x202111830

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Revista Contabilidade & Finanças

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Original Article • Rev. contab. finanç. 32 (87) • Sep-Dec 2021 • https://doi.org/10.1590/1808-057x202111830 copy

The impact of audit rotation on the comparability of financial reports^* * This paper was presented at the XIX USP International Conference in Accounting, São Paulo, SP, Brazil, July 2019. ^,^ This study was carried out with the support of the Coordination for the Improvement of Higher Education Personnel (Capes) - Financing Code 001.

Authorship SCIMAGO INSTITUTIONS RANKINGS

Abstract

This study aims to assess the effect of the rotation and tenure of audit firm and audit partner on the comparability and consistency of financial reports. Several studies have addressed the effect of auditor rotation on the quality of financial reports, but none of them focused specifically on the impact on the comparability and consistency of financial reports. Around the world, the impact of mandatory rotation of audit partner and audit firm is being discussed in academia and regulatory bodies. The peculiarity of the Brazilian regulatory environment allows us to contribute to the discussions on the effects of implementing mandatory auditor rotation. Our sample included 50 companies for which we analyzed data from 2012 to 2018. To measure comparability, we used the similarity of the accounting function model by DeFranco, Kothari and Verdi (2011), and to measure consistency we used the adaptations to this model proposed by Ribeiro (2014). For data analysis, we used descriptive statistics and multivariate panel analysis. Our results suggest that the rotation (mandatory and voluntary) of audit firm and audit partner does not affect the comparability and consistency of financial reports. Results also suggest that auditor-client relationships of up to three years contribute to a significant increase in comparability and consistency, indicating that mandatory rotation does not impair investors’ ability to compare the information concerning their investments. In addition, regulators are shown that a possible reduction in the mandatory rotation term (from five to three years, as in Italy) would be in line with market practices and would imply an increase in the comparability and consistency of financial information.

Keywords:
comparability; auditor rotation; consistency

Dependent variables
Variable	Description	Operation	References
Comparability (COMPM)	Mean individual comparability based on pairs in the sector	${R O A}_{i t} = a_{i} + β_{i} {R e t u r n}_{i t} + ε_{i t}$	DeFranco et al. (2011DeFranco, G., Kothari, S. P., & Verdi, R. S. (2011). The benefits of financial statement comparability. Journal of Accounting Research, 49(4), 895-931.)
Consistency (CONSIS)	Mean individual consistency	${R O A}_{i t} = a_{i} + β_{i} {R e t u r n}_{i t} + ε_{i t - 1}$	Ribeiro (2014Ribeiro, A. M. (2014). Poder discricionário do gestor e comparabilidade dos relatórios financeiros: uma análise dos efeitos da convergência do Brasil às IFRS (Tese de Doutorado). Universidade de São Paulo, São Paulo.)
Independent variables
Variable	Description	Operation	References
Mandatory rotation (MANDATORY)	Dichotomous variable measuring whether audit firm rotation occurred up to or after five years since the last audit firm rotation	Dummy variable with two categories: (1) mandatory rotation, (0) no rotation or voluntary rotation of the audit firm	Kim, Lee and Lee. (2015Kim, H., Lee, H., & Lee, J. E. (2015). Mandatory audit firm rotation and audit quality. Journal of Applied Business Research, 31(3), 1089.) and Silvestre, Costa and Kronbauer (2018Silvestre, A. O., Costa, C. M., & Kronbauer, C. A. (2018). Audit rotation and earnings quality: An analysis using discretionary accruals. BBR - Brazilian Business Review, 15(5), 410-426.)
Voluntary rotation (VOLUN)	Dichotomous measuring whether independent audit firm rotation occurred up to five years since the last audit firm rotation	Dummy variable with two categories: (1) voluntary rotation, (0) no rotation or mandatory rotation of audit firm	Kim et al. (2015Kim, H., Lee, H., & Lee, J. E. (2015). Mandatory audit firm rotation and audit quality. Journal of Applied Business Research, 31(3), 1089.) and Silvestre et al. (2018Silvestre, A. O., Costa, C. M., & Kronbauer, C. A. (2018). Audit rotation and earnings quality: An analysis using discretionary accruals. BBR - Brazilian Business Review, 15(5), 410-426.)
Audit partner rotation (PARTROTATION)	Dichotomous variable measuring whether the company was audited by a different audit partner from the previous year	Dummy variable with two categories: (1) rotation or (0) no rotation of audit partner	Jenkins and Vellury (2008Jenkins, D. S., & Velury, U. (2008). Does auditor tenure influence the reporting of conservative earnings? Journal of Accounting and Public Policy, 27(2), 115-132.)
Audit firm size (SIZEROTATION)	Dichotomous variable measuring whether the audit firm is the same size as the audit firm of the previous year. Audit firms were classified into two sizes, Big 4 or not Big 4	Dummy variable with two categories: (1) change or no change (0) to audit firm size, considering size as Big 4 or not Big 4	Li (2010Li, D. (2010). Does auditor tenure affect accounting conservatism? Further evidence. Journal of Accounting and Public Policy, 29(3), 226-241.), Lawrence, Minutti-Meza and Zhang (2011Lawrence, A., Minutti-Meza, M., & Zhang, P. (2011). Can Big 4 versus non-Big 4 differences in audit-quality proxies be attributed to client characteristics? The Accounting Review, 86(1), 259-286.) and Francis et al (2014Francis, J. R., Pinnuck, M. L., & Watanabe, O. (2014). Auditor style and financial statement comparability. The Accounting Review, 89(2), 605-633.)
Short audit firm tenure (STENFIRM)	Dichotomous variable measuring whether the audit firm’s tenure is short (1 to 3 years)	Dummy variable with two categories: (1) tenure of 1 to 3 years, (0) tenure longer than 3 years	Johnson et al. (2002Johnson, V. E., Khurana, I. K., & Reynolds, J. K. (2002). Audit‐firm tenure and the quality of financial reports. Contemporary Accounting Research, 19(4), 637-660.), Harris and Whisenant (2012Harris, K., & Whisenant, S. (2012). Mandatory audit rotation: an international investigation (Doctoral Dissertation, University of Houston). Retrieved from https://uh-ir.tdl.org/bitstream/handle/10657/ETD-UH-2012-05-372/HARRIS-.pdf?sequence=2&isAllowed=y. https://uh-ir.tdl.org/bitstream/handle/1... ) and Bell, Causholli and Knechel (2015Bell, T. B., Causholli, M., & Knechel, W. R. (2015). Audit firm tenure, non‐audit services, and internal assessments of audit quality. Journal of Accounting Research, 53(3), 461-509.)
*Short audit partner tenure* (STENPARTNER)**	Dichotomous variable measuring whether audit partner tenure is short (1 to 3 years)	Dummy variable with two categories: (1) tenure of 1 to 3 years, (0) tenure longer than 3 years	Johnson et al. (2002Johnson, V. E., Khurana, I. K., & Reynolds, J. K. (2002). Audit‐firm tenure and the quality of financial reports. Contemporary Accounting Research, 19(4), 637-660.), Chi et al. (2011Chi, W., Lisic, L. L., & Pevzner, M. (2011). Is enhanced audit quality associated with greater real earnings management? Accounting Horizons, 25(2), 315-335.) and Garcia-Blandon and Argiles Bosch (2017Garcia-Blandon, J., & Argiles-Bosch, J. M. (2017). The interaction effects of firm and partner tenure on audit quality. Accounting and Business Research, 47(7), 810-830.)
Market-to-book (MB)	Variable measuring business growth expectation for the market	Market value / Book equity	Lee, Li and Yue (2006Lee, C. W. J., Li, L. Y., & Yue, H. (2006). Performance, growth and earnings management. Review of Accounting Studies, 11(2-3), 305-334.), Mcvay, Nagar and Tang (2006McVay, S., Nagar, V., & Tang, V. W. (2006). Trading incentives to meet the analyst forecast. Review of Accounting Studies, 11(4), 575-598.), Ribeiro et al. (2016aRibeiro, A. M., do Carmo, C. H. S., Lopes Fávero, L. P., & de Carvalho, L. N. G. (2016a). Comparabilidade X uniformidade dos relatórios financeiros: uma análise empírica durante o período de transição regulatória da contabilidade brasileira ao padrão internacional. Advances in Scientific & Applied Accounting, 9(3), 262-282.) and Ribeiro et al. (2016bRibeiro, A. M., do Carmo, C. H. S., Lopes Fávero, L. P., & de Carvalho, L. N. (2016b). Poder discricionário do gestor e comparabilidade dos relatórios financeiros: uma análise do processo de transição regulatória da contabilidade brasileira. Revista Contabilidade & Finanças, 27(70), 12-28.)
Degree of operating leverage (DOL)	Measurement of operational performance and the company’s cost structure	Gross Profit / (Gross Profit - Selling and Administrative Expenses)	Sohn (2016Sohn, B. C. (2016). The effect of accounting comparability on the accrual-based and real earnings management. Journal of Accounting and Public Policy, 35(5), 513-539.), Francis, Hanna and Vincent (1996Francis, J. R., Hanna, J. D., & Vincent, L. (1996). Causes and effects of discretionary asset write-offs. Journal of Accounting Research, 34, 117-134.), *Ribeiro et al. (2016aRibeiro, A. M., do Carmo, C. H. S., Lopes Fávero, L. P., & de Carvalho, L. N. G. (2016a). Comparabilidade X uniformidade dos relatórios financeiros: uma análise empírica durante o período de transição regulatória da contabilidade brasileira ao padrão internacional. Advances in Scientific & Applied Accounting, 9(3), 262-282.) and Ribeiro et al. (2016b*Ribeiro, A. M., do Carmo, C. H. S., Lopes Fávero, L. P., & de Carvalho, L. N. (2016b). Poder discricionário do gestor e comparabilidade dos relatórios financeiros: uma análise do processo de transição regulatória da contabilidade brasileira. Revista Contabilidade & Finanças, 27(70), 12-28.)
Size (SIZE)	Logarithm of the company’s total assets	Napierian logarithm of total assets	Watts and Zimmerman (1986Watts, R. L., & Zimmerman, J. L. (1986). Positive accounting theory. Englewood Cliffs, NJ.), Doyle, Ge and McVay (2007Doyle, J., Ge, W., & McVay, S. (2007). Determinants of weaknesses in internal control over financial reporting. Journal of Accounting and Economics, 44(1-2), 193-223.), Ribeiro et al. (2016aRibeiro, A. M., do Carmo, C. H. S., Lopes Fávero, L. P., & de Carvalho, L. N. G. (2016a). Comparabilidade X uniformidade dos relatórios financeiros: uma análise empírica durante o período de transição regulatória da contabilidade brasileira ao padrão internacional. Advances in Scientific & Applied Accounting, 9(3), 262-282.) and Ribeiro et al. (2016bRibeiro, A. M., do Carmo, C. H. S., Lopes Fávero, L. P., & de Carvalho, L. N. (2016b). Poder discricionário do gestor e comparabilidade dos relatórios financeiros: uma análise do processo de transição regulatória da contabilidade brasileira. Revista Contabilidade & Finanças, 27(70), 12-28.)
Economic crisis (CRISIS)	Variable measuring whether annual variation in Gross Domestic Product (GDP) is negative	Dummy variable with two categories: (1) negative variation in GDP, (0) positive variation in GDP .	Cohen and Zarowin (2007Cohen, D. A., & Zarowin, P. (2007). Earnings management over the business cycle. Retrieved from https://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.1060.381&rep=rep1&type=pdf https://citeseerx.ist.psu.edu/viewdoc/do... )
Sector	Level 3 NAICS	Dummy variable representing each company’s economic sector: (0) Construction, (1) Electricity, (2) Telecommunications, (3) Slaughterhouses, (4) Auto parts, (5) Rental companies and (6) Other industries.	Verrecchia and Weber (2006Verrecchia, R. E., & Weber, J. (2006). Redacted disclosure. Journal of Accounting Research, 44(4), 791-814.) and Bagnoli and Watts (2010Bagnoli, M., & Watts, S. G. (2010). Oligopoly, disclosure, and earnings management. The Accounting Review, 85(4), 1191-1214.)

Variables	Mean	Standard Deviation			Minimum	Maximum	Number of Observations
Variables	Mean	Overall	Between	Whithin	Minimum	Maximum	Number of Observations
COMPM	-4.245	2.401	1.719	1.664	-10.969	-0.057	260
CONSIS	-0.874	0.866	0.553	0.701	-4.711	-0.118	260
MB	1.379	0.994	1.031	0.489	0.041	5.496	260
DOL	1.002	1.571	1.273	0.940	-3.205	7.436	260
SIZE	15.592	1.137	1.150	0.207	13.301	18.702	260

Independent variables	Comparability				Consistency
	Model 1		Model 2		Model 3		Model 4
	Audit firm		Audit partner		Audit firm		Audit partner
	Coef.	t-stat	Coef.	t-stat	Coef.	t-stat	Coef.	t-stat
MANDATORY	-0.498	-1.82			-0.165	-1.61
VOLUN	-0.157	-0.39			-0.188	-0.90
STENFIRM	0.691	2.26**			0.348	2.04*
PARTROTATION			-0.227	-1.17			-0.014	-0.13
STENPARTNER			0.666	1.65			0.189	1.00
SIZEROTATION	0.099	0.19	0.131	0.27	-0.550	-1.47	-0.639	-1.93
MB	0.041	0.35	0.446	0.40	0.088	1.31	0.081	1.02
DOL	0.172	1.75	0.175	1.70	0.103	2.98**	0.112	3.27**
SIZE	-0.219	-1.88	-0.224	-1.77	-0.111	-1.43	-0.085	-1.00
CRISIS	-0.973	-3.54**	-1.063	-4.28**	0.601	0.45	-0.053	-0.43
Constant	-2.623	-1.36	-2.601	-1.23	0.337	0.28	0.046	0.03
Sector control	Yes		Yes		Yes		Yes
R²	0.5011		0.4963		0.2042		0.1756
F-statistic/Wald	56.31**		44.30**		64.84**		44.15**
Observations	260		260		260		260

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