Pertemuan 6 PDF

THE ACCOUNTING REVIEW American Accounting Association
Vol. 90, No. 6 DOI: 10.2308/accr-51054

2015
pp. 2143–2176
Capital Market Consequences of Audit

Partner Quality
Daniel Aobdia
Northwestern University and PCAOB, Center for Economic Analysis
Chan-Jane Lin
National Taiwan University
Reining Petacchi
Massachusetts Institute of Technology
ABSTRACT: This paper examines whether the identity of the individual audit partners
provides informational value to capital market participants beyond the value provided by
the identity of the audit firms. Using data from Taiwan, where firms are mandated to
disclose the names of the engagement partners, we find a positive association between
the partner’s quality and the client firm’s earnings response coefficient. We also find a
positive market reaction when a firm replaces a lower quality partner with a higher quality
one. Moreover, we find evidence that firms audited by higher quality partners experience
smaller initial public offering (IPO) underpricing and are able to obtain better debt
contract terms. Overall, these results suggest that the quality of engagement partners
matters to capital market participants.
Keywords: individual auditors; audit quality; capital market consequences.
We thank Michael L. Ettredge (editor), two anonymous referees, Michelle Hanlon, John Hughes, Bill Kinney, Robert
Magee, Miguel Minutti-Meza, Joseph Piotroski, Brett Trueman, Rodrigo Verdi, Beverly Walther, Joseph Weber, the
staff of the Public Company Accounting Oversight Board (PCAOB), and workshop participants at University of
California, Los Angeles, and the 2014 21st University of Illinois Symposium on Audit Research for helpful comments on
earlier versions of this paper. We also thank Hsiao-Lun Lin for kindly providing part of the data on auditor changes and
senior partners at the Big 4 accounting firms in Taiwan (Ernst & Young, Deloitte & Touche, KPMG, and
PricewaterhouseCoopers) and for insightful discussions on the audit practice in Taiwan. We gratefully acknowledge
financial support of E.Sun Commercial Bank, Taiwan, the Kellogg School of Management, and the Massachusetts
Institute of Technology Sloan School of Management.
Previous versions of this paper were circulated as ‘‘Capital Market Consequences of Individual Audit Partners.’’
Professor Aobdia co-wrote this paper prior to joining the PCAOB. The PCAOB, as a matter of policy disclaims
responsibility for any private publication or statement by any of its Economic Research Fellows and employees. The
views expressed in this paper are the views of the author and do not necessarily reflect the views of the Board, individual
Board members, or staff of the PCAOB.
Supplemental material can be accessed by clicking the link in Appendix B.
Editor’s note: Accepted by Michael L. Ettredge.
Submitted: August 2013
Accepted: February 2015
Published Online: February 2015
2143
2144 Aobdia, Lin, and Petacchi
I. INTRODUCTION
T
his paper investigates whether the identity of the engagement partners provides
informational value to capital market participants. Prior research has documented,
theoretically and empirically, that hiring a higher quality audit firm or practice office
leads to positive capital markets consequences.1 For example, Titman and Trueman (1986) and
Datar, Feltham, and Hughes (1991) show that hiring a higher quality audit firm provides a positive
signal to uninformed investors about the underlying firm value. However, little is known at a more
granular level, perhaps because in the U.S., detailed data on the personnel implementing the audit
are unavailable. Francis (2011, 134) suggests that ‘‘audits are of higher quality when undertaken by
competent people’’; however, ‘‘the fact remains that we know very little about the people who
conduct audits.’’
The purpose of this paper is to fill this gap by assessing the informational role of engagement
partners. Ex ante, given that audit firms use standardized audit processes and have large reputation
capital, it is unclear whether individual partners provide additional informational value to the capital
market participants beyond the identity of the audit firms they work for. To assess the informational
value of engagement partners, we investigate the following questions: Do the markets respond
positively when a firm switches from a lower quality partner to a higher quality partner? Do the
markets perceive earnings to be more informative when higher quality partners conduct the audits?
Do investors reward companies for using higher quality engagement partners? In particular, do
companies who hire higher quality partners experience less initial price offering (IPO) underpricing
and receive better debt contract terms? The answers to these questions present new insights into the
economic consequences of engagement partner quality and provide a market-based assessment on
the value investors place on the quality of these partners.
We conduct our analyses using the setting in Taiwan, where individual partners are required
to sign the audit reports. Given that the identity of the partners is disclosed, audit partners develop
a track record over time, which is observable to investors. If investors value the quality of audit
partners, then we would expect a positive association between the quality of audit partners and
various capital market outcomes. To measure engagement partner audit quality, we examine
client firms’ unsigned discretionary accruals, a measure well established and extensively used in
the auditing literature (e.g., Lim and Tan 2008; Francis and Yu 2009; DeFond and Zhang 2014).2
We then employ the fixed effect methodology developed by Bertrand and Schoar (2003) to
quantify the quality of each engagement partner conditional on the quality of the audit firm and
the client firm’s innate reporting characteristics. Specifically, we regress unsigned discretionary
accruals on partner, audit firm, client firm, and year fixed effects, as well as a set of control
variables. Our measure of partner quality is the individual partner fixed effect coefficients
estimated from the regression.
To avoid using forward-looking data, we use the sample period from 1995 to 2005 to estimate
partner quality, and from 2006 to 2010 to run the capital market analyses. In our estimation sample,
we find that engagement partners have incremental effects on their clients’ accrual quality that
cannot be explained by characteristics of the firm and the audit firm. This result is consistent with
Gul, Wu, and Yang (2013), who find that audit quality varies statistically and economically across
1
For theoretical models, see, for example, Titman and Trueman (1986), Datar et al. (1991), and Dye (1993). For
empirical work, see, for example, Teoh and Wong (1993), Francis, Maydew, and Sparks (1999), Reynolds and
Francis (2001), Francis and Ke (2006), and Francis and Yu (2009).
2
We discuss the rationale of using an accrual-based measure of audit quality in Section II.
The Accounting Review

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Capital Market Consequences of Audit Partner Quality 2145
individual auditors.3 We further validate the accuracy of our measure using a series of out-of-
sample tests. We find that clients of high quality partners tend to have smaller abnormal accruals
and are less likely to meet benchmark earnings targets and to restate their financial statements. We
also find that high quality partners are less likely to receive sanctions from the regulator. These
results suggest that our measure captures the quality of engagement partners.
The focus of the paper is to assess whether engagement partners provide informational value to
capital market participants beyond the value provided by the audit firms. Therefore, we condition
all our capital market analyses on the quality of audit firms. Using the testing period from 2006 to
2010, we find a positive association between earnings response coefficients (ERCs) and individual
partners’ quality. This result suggests that investors perceive earnings to be more informative when
higher quality partners perform the audit. We also find that the markets react positively when the
firm switches from a lower quality partner to a higher quality partner. Specifically, we find that
replacing a partner with one having quality one-quartile higher is associated with a positive
abnormal return ranging from 0.7 percent to 1.2 percent, depending on the estimation window.
Finally, the IPO literature shows that when a firm sells its shares for the first time, the firm value is
imperfectly known to the investors, and hiring a good auditor can serve as a positive signal to the
market (e.g., Titman and Trueman 1986; Beatty 1989). We find consistent results at the engagement
partner level. Specifically, we find that firms audited by higher quality partners experience a lower
level of underpricing when they go public.
Our results in the equity markets extend to the debt markets. We find that high quality
engagement partners can reduce the information asymmetry between borrowers and banks,
resulting in lower monitoring cost and better contract terms. Specifically, we find that firms audited
by higher quality partners pay lower interest rates, have greater access to credit, and are less likely
to be required to post collateral.
Our paper contributes to the literature in several dimensions. First, we are the first to investigate
and provide large-sample evidence that the names of the engagement partners provide informational
value to capital market participants beyond the value provided by the identity of the audit firms. In
particular, the study responds to the call by DeFond and Francis (2005), who suggest using settings
in other countries where the names of the engagement partners are required to be disclosed in audit
reports to study auditor behavior and audit quality at the individual engagement partner level. The
paper is also timely in that recent regulatory changes around the world have begun to require
disclosure of the names of the engagement partners. For example, in 2006, the European Union
adopted the Eighth Company Law Directive, which requires the engagement partner to sign the
audit report (Directive 2006/43/EC, Article 28; see: http://www.esma.europa.eu/system/files/dir_
2006_43_EN.pdf ). The Public Company Accounting Oversight Board (PCAOB 2013, Release No.
2013-009) is also considering mandating the disclosure of the names of the engagement partners,
and the Board argues that disclosing such information would help financial statement users
‘‘evaluate the extent of an engagement partner’s experience on a particular type of audit and, to a
degree, his or her track record. Such information could be useful to investors making investment
decisions’’ (PCAOB 2009, 9). Our findings support this assertion.4
3
As noted by Bertrand and Schoar (2003), this type of analysis does not establish causality. In particular, it is possible
that firms with higher accrual quality tend to pair with higher quality engagement partners. However, the tenor of our
results does not depend on the causal inferences between firm quality and partner quality, because the choice of a
specific partner provides a signal about the quality of the firm to the capital markets (Titman and Trueman 1986).
Therefore, the disclosure of the partner name itself has informational value to the capital market participants.
4
A related paper by Carcello and Li (2013) uses the setting in the United Kingdom and finds that requiring the
engagement partner to sign the audit report has a positive effect on audit quality.

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The remainder of this paper is organized as follows. Section II develops the hypotheses.
Section III describes the sample, and Section IV estimates individual audit partners’ quality. Section
V assesses the equity market consequences of the audit partners, and Section VI assesses the debt
market consequences. Section VII conducts robustness tests, and Section VIII concludes.
II. HYPOTHESIS DEVELOPMENT
Engagement Partner Quality and Capital Market Consequences

Prior research on audit quality largely focused the analyses at the audit firm (e.g., DeAngelo
1981; Palmrose 1988; Francis et al. 1999) or branch office level (e.g., Reynolds and Francis 2001;
Francis and Yu 2009). Recent research has begun to push the unit of the analyses further down,
investigating whether engagement team personnel affect audit quality. For example, using data
from Taiwan, Chen, C.-J. Lin, and Y.-C. Lin (2008) investigate the relation between audit partner
tenure and client earnings quality. Using data from China, Chen, Sun, and Wu (2010) study the
impact of client importance on individual auditors’ propensity to issue modified audit opinions.
Using data from Sweden and Australia, Zerni (2012) and Goodwin and Wu (2014) study industry
expertise at the partner level. However, to date, studies conducting analyses at the individual auditor
level remain scarce. DeFond and Francis (2005) and Francis (2011) call for more research on
auditor behavior and audit quality at the individual engagement partner level.
Responding to this call, a recent paper by Gul et al. (2013) uses individual auditor data from
China and finds that the effects of individual auditors on audit quality are both economically and
statistically significant. In this paper, we extend Gul et al. (2013) and examine the economic
consequences of hiring a high quality engagement partner. In particular, we are interested in the
informational effects of engagement partners on various capital market outcomes incremental to the
effects of audit firms.
A high quality engagement partner can provide informational value to capital market
participants through two channels. First, hiring a high quality partner can act as a positive signal to
uninformed investors about the underlying firm value. Titman and Trueman (1986) show that a
higher quality auditor is able to supply more precise information about the firm’s value; thereby,
entrepreneurs with more favorable information about their firms will choose higher quality auditors.
Recognizing this behavior, investors are able to infer the entrepreneur’s private information from
her choice of auditor. This signaling story is in similar spirit to Dye (1993), who argues that the
informational value of an audit varies based on the ‘‘perceived’’ audit quality. Second, if a high
quality partner can produce more accurate information about the firm (Titman and Trueman 1986),
then hiring a high quality partner reduces the information asymmetry between the firm and its
investors. Since engagement partners can provide informational value to market participants
through both the signaling and information accuracy channels, we cannot draw causal inferences
from our empirical analyses. Instead, our objective is to assess whether capital market participants
care about the quality of engagement partners.
We examine the following four potential effects of engagement partners on the capital markets:
the extent to which new earnings are capitalized into the stock price, the market’s reaction to the
announcement of a partner change, IPO underpricing, and debt contracting. Regarding the first,
prior studies commonly use the extent to which new earnings information is capitalized into the
stock price as a measure for investors’ perception of earnings quality. They document that this
valuation effect is associated with various audit firm characteristics, such as size (Teoh and Wong
1993), tenure (Ghosh and Moon 2005), and whether the firm provides nonaudit services (Francis
and Ke 2006). If the quality of the engagement partners matters to equity market participants, then
we would expect the market’s valuation of earnings to be higher when higher quality engagement

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partners conduct the audits. On the other hand, given the relatively large size of audit teams
working on a given account and the use of fairly standardized processes across clients, it is possible
that the identity of the audit firm is the only parameter that capital market participants focus on. Our
first hypothesis, stated in alternative form, is:
H1: Earnings are capitalized in the stock price to a larger extent when higher quality
engagement partners conduct the audits.
If the markets perceive earnings to be more informative when audited by higher quality
partners, then we would expect the markets to react positively when a firm switches from a low
quality partner to a high quality partner. This prediction is consistent with prior research’s finding
that the market reaction to an auditor change depends on auditor characteristics. For example,
Eichenseher, Hagigi, and Shields (1989) find a positive market reaction when a firm switches from
a non-Big 8 audit firm to a Big 8 audit firm. Knechel, Naiker, and Pacheco (2007) further show that
the market reaction to an auditor switch depends on whether the successor auditor is an industry
specialist. Our second hypothesis, stated in alternative form, is:
H2: Stock markets react positively to the announcement of a partner change when the firm
switches to a higher quality engagement partner.
Studies on IPOs argue that when a firm offers shares for the first time, the quality of the auditor
chosen provides a signal about the firm’s true value to uninformed investors (Titman and Trueman
1986; Datar et al. 1991). Balvers, McDonald, and Miller (1988) argue that to preserve their
reputation capital, investment bankers prefer high quality auditors to participate in the underwriting
coalition. They further show that high quality auditors can reduce the level of IPO underpricing.
Motivated by theoretical studies of ex ante uncertainty and underpricing of the IPO (Rock 1986;
Beatty and Ritter 1986), Beatty (1989) finds similar evidence that firms hiring more reputable
accounting firms exhibit smaller IPO underpricing. If high quality engagement partners are able to
mitigate the informational uncertainty associated with a new equity issue, then we would expect
firms hiring higher quality partners to experience a lower level of IPO underpricing. Our third
hypothesis, stated in alternative form, is:
H3: Firms audited by higher quality engagement partners are associated with a lower level of
IPO underpricing.
Quality audits are also valuable to debt market participants. Financial statements are commonly
used in debt contracts, and quality audits reduce creditors’ monitoring costs (Watts and Zimmerman
1986). Under the threat of competition, creditors will be forced to pass along these cost reductions
to borrowers in the form of lower interest rates or better contract terms. Prior research finds
supporting evidence for this argument. For example, Blackwell, Noland, and Winters (1998) find
that private companies whose financial statements are audited pay lower interest rates on their bank
loans than those whose financial statements are not audited. Minnis (2011) further finds that lenders
place more weight on audited financial information in setting the loan rates. Mansi, Maxwell, and
Miller (2004) provide corresponding evidence in the public debt markets, documenting that
companies employing better quality auditors enjoy lower cost of debt. If high quality partners
enhance the credibility of the financial statements and, hence, reduce creditors’ monitoring costs,
then we would expect firms hiring higher quality partners to obtain better debt contract terms. Our
fourth hypothesis, stated in alternative form, is:
H4: Firms audited by higher quality engagement partners are associated with more favorable
debt contract terms.

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Accrual-Based Measure of Engagement Partner Quality

We infer a partner’s quality from her clients’ earnings properties. Specifically, we consider a
partner to be higher quality if her clients, on average, exhibit a lower level of discretionary accruals.
We choose to rely on an accrual-based measure of partner quality for the following reasons. First,
accrual quality directly maps into the concept of audit quality and is one of the most common
proxies for audit quality in the literature.5 A recent review paper by DeFond and Zhang (2014, 14)
suggests that high quality auditors should consider ‘‘not only whether the client’s accounting
choices are in technical compliance with GAAP, but also how faithfully the financial statements
reflect the firm’s underlying economics.’’ Given that the goal of various accrual models is to capture
the extent to which the financial reporting reflects the underlying economic condition of the firm,
accrual quality fits well into the concept of audit quality.6
Second, previous studies have established a relationship between accrual quality and various
capital market consequences that we investigate in the paper. For example, Dechow, Ge, and
Schrand (2010) show that accrual quality is positively associated with ERCs. Boulton, Smart, and
Zutter (2011) provide evidence that earnings quality reduces IPO underpricing around the world.
Francis, LaFond, Olsson, and Schipper (2005) provide evidence on the impact of accrual quality on
the interest cost of debt. Bharath, J. Sunder, and S. Sunder (2008) further show that accrual quality
not only affects interest costs, but also affects other debt contract terms. Overall, these studies
provide evidence that accrual quality is a reasonable proxy for managerial opportunistic behavior,
and market participants care about accrual quality. To the extent that high quality partners can
enhance client accrual quality, we would expect them to elicit positive capital market consequences.
From an empirical standpoint, accrual quality is also the most suitable proxy for our study
because of its continuous nature. Other proxies for audit quality, such as whether the firm incurs a
small profit or files a restatement, require an estimation of nonlinear models (probit or logit). As
detailed below, we follow the methodology in Bertrand and Schoar (2003) to quantify the quality of
each engagement partner, and this methodology requires us to include a large set of fixed effects.7
Including a large set of fixed effects in nonlinear models is problematic because it makes the
maximum likelihood estimators inconsistent (Greene 2004).
III. SAMPLE SELECTION

The regulations in Taiwan require the financial reports of public companies to be certified by
two audit partners.8 One audit partner is the lead partner, who is in charge of planning and
implementing the audit engagement. The other audit partner is the review partner, who is usually
not actively involved in the audit and only reviews the final audit report.9 Public companies also
must disclose the names of the partners and the audit firms. These distinctive features of the
Taiwanese audit market allow us to track the audit partners and audit firms across companies over
5
Studies that use accrual quality to proxy for audit quality include, but are not limited to, Reynolds and Francis (2001),
Balsam, Krishnan, and Yang (2003), Krishnan (2003), J. Myers, L. Myers, and Omer (2003), Chen et al. (2008), Lim
and Tan (2008), Chi, Huang, Liao, and Xie (2009), Francis and Yu (2009), and Carcello and Li (2013).
6
In contrast, other common measures of audit quality, such as audit opinions and client restatement history, are
narrower in scope in that they only reflect whether the auditor detects and reports the breach of GAAP (by issuing an
unclean opinion or requiring a restatement).
7
We need to include about 1,000 fixed effect dummies in our model.
8
Public companies are those listed on the Taiwan Stock Exchange or the GreTai Securities Market (i.e., over-the-
counter market). Before November 2001, private companies whose capital level exceeded a certain threshold were
also required to file audited financial statements. However, most private companies ceased to file audited financial
statements after the rule was lifted in 2001 (Chi, Myers, Omer, and Xie 2011).
9
Private conversations with the Big 4 audit firms in Taiwan suggest that the main reason for this arrangement is to
reduce audit cost due to the high competition in the Taiwanese audit market.

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time and to study the effects of individual audit partners on the capital markets, conditional on the
effects of audit firms.
Our main data source is the Taiwan Economic Journal (TEJ) database. TEJ covers all public
companies in Taiwan and collects data on the financial statements, the restatement history, the signing
partners and the accounting firm who implement the audit, the regulatory sanction history of the
partners, the dates of the quarterly earnings announcements, the company’s stock prices and IPO date, as
well as data on loan borrowings and corporate credit ratings. We supplement the TEJ data by manually
collecting the announcement dates of audit partner changes and the names of the new and old partners
and the audit firms from the Market Observation Post System (MOPS). All the public companies in
Taiwan are required to announce their material events on the MOPS. From the MOPS, we also collect
announcements related to changes in executives, dividends payouts, capital raising, and restatements to
control for potential confounding events in our market reaction to a partner change test.10
Our sample period is from 1995 to 2010. To avoid using forward-looking information in our
capital market tests, we use data from 1995 to 2005 to estimate the engagement partner quality, and
data from 2006 to 2010 to conduct the capital market analyses. This research design is similar to
Yang (2012), who studies the capital market consequences of managers’ disclosure styles. We have
6,826 firm-year observations in our partner quality estimation period of 1995–2005.11 The number
of observations in each capital market test varies based on data requirement.
Table 1, Panel A reports the industry distributions for sample firms who have non-missing data
for estimating engagement partner quality during 1995–2005 and for all public firms during the same
sample period. Industry classification is based on the Taiwan Stock Exchange industry codes. The
sample contains firms in every economic sector and does not show any particular industry clustering.
The industry distributions between the sample firms and all public firms are fairly comparable.
IV. ESTIMATION OF INDIVIDUAL AUDIT PARTNER QUALITY
Empirical Model
We measure the quality of each audit partner using her clients’ discretionary accruals. Since
managers can manage earnings upward or downward depending on their objectives, and accrual-
based earnings management reverses over time (Dechow, Hutton, Kim, and Sloan 2012), we use
unsigned discretionary accruals to proxy for audit quality. We estimate discretionary accruals using
the cross-sectional modified Jones (1991) model (Dechow, Sloan, and Sweeney 1995; Kothari,
Leone, and Wasley 2005):12
TAt =ASSETt1 ¼ b1 ð1=ASSETt1 Þ þ b2 ðDSALESt DARt Þ=ASSETt1
þb3 PPEt =ASSETt1 þ b4 ROAt1 þ et ; ð1Þ
10
There are no announcements related to mergers, acquisitions, and restructuring activities on the dates of partner
change in our sample.
11
We start with 11,156 firm-year observations that have non-missing financial statement data. Requiring non-missing
partner and audit firm data slightly reduces the sample to 11,147. Requiring non-missing return data to construct the
control variables, such as book-to-market ratio (BTM) and business model shock (BMS), further reduces the sample to
6,826.
12
DeFond and Zhang (2014) suggest that the Jones (1991) discretionary accrual model is the most frequently used
measure of client financial reporting quality in the auditing literature. As a robustness test, we also estimate accrual
quality based on a modified version of the Dechow and Dichev (2002) model suggested by McNichols (2002) and
Francis et al. (2005). We find consistent, albeit slightly weaker results. One explanation for the slightly weaker results
is that the Dechow and Dichev (2002) model only focuses on short-term working capital accruals (Dechow et al.
2010). Consequently, the model is unable to measure the auditor’s role in detecting potential distortions in long-term
accruals. This could increase noise in the estimation of individual engagement partners’ quality.

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TABLE 1
Sample Description
Panel A: Industry Distribution

All
Sample Public
TSE Industry Code Industry Name Firms (%) Firms (%)
01 Cement 1.1 0.6
02 Food 3.3 2.0
03 Plastic 3.5 2.4
04 Textile & Fiber 7.2 4.7
05 Electrical Engineering & Machinery 5.2 5.4
06 Appliance & Cable 2.0 1.3
08 Glass & Ceramics 0.6 0.4
09 Papermaking 1.1 0.6
10 Steel & Iron 4.5 3.4
11 Rubber 1.5 0.9
12 Auto 0.6 0.4
14 Construction 6.8 5.2
15 Sea Transport 2.9 2.1
16 Tourism 1.4 1.1
18 Wholesale & Retailing 2.0 1.5
19, 20 Miscellaneous & Other 7.0 5.7
21 Chemical 3.9 3.3
22 Biotechnology & Medical Care 2.0 3.7
23 Oil, Gas, & Electricity 1.4 1.1
24 Semiconductor 7.3 8.9
25 Computer & Peripheral Equipment 7.2 7.7
26 Optoelectronic 4.5 6.9
27 Communications & Internet 4.0 5.4
28 Electronic Components 10.2 13.7
29 Electronic Products Distribution 2.4 3.2
30 Information Service 2.4 3.1
31 Electronic—Other 4.0 5.4
Total 100 100
Panel B: Sample Descriptive Statistics for Audit Firms and Individual Partners
Variable Mean Std. Dev. p25 p50 p75
Number of audit firms per year 14.364 2.335 12 16 16
Number of clients per audit firm-year 37.722 56.858 2 11 46
Number of lead partners per audit firm-year 10.044 13.195 1 4 13
Number of clients per lead partner-year 3.758 2.781 2 3 5
This table provides information on the sample composition during the partner quality estimation period of 1995–2005.
Panel A provides a comparison of the industry distribution between the sample firms and the whole universe of the public
firms. Panel B provides descriptive statistics for audit firms and individual partners.

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where TA is total accruals, measured as earnings before extraordinary items minus net cash flow
from operations; DSALES is change in net sales; DAR is change in net accounts receivable; PPE is
net property, plant, and equipment; and ROA is the rate of return on assets. Following Kothari et al.
(2005), we control for ROA to increase the power of the model. We deflate both the dependent and
independent variables by lagged total assets and estimate Equation (1) by industry-year.
Discretionary accrual (DA) is the residual from the model and the absolute value of DA is our
measure of audit quality, ABSDA.13
To quantify each audit partner’s quality, we follow the methodology developed by Bertrand
and Schoar (2003) and estimate the following model:
ABSDAit ¼ bXit þ Rat Yeart þ Rcm Audit Partnerm þ Rhj Audit Firmj þ Rdi Clienti þ eit : ð2Þ
Equation (2) includes an indicator variable for each year (year fixed effects), client (firm fixed
effects), audit firm (audit firm fixed effects), and audit lead partner (audit partner fixed effects).14
The client fixed effects control for time-invariant firm characteristics that may affect accrual quality.
The audit firm fixed effects control for the effects of the audit firm on accrual quality. We focus on
the audit partner fixed effects, whose estimates are our proxy for engagement partner quality. X is a
vector of time-varying characteristics at the client, audit firm, and audit partner levels that prior
studies find to affect accrual quality (e.g., DeFond and Jiambalvo 1994; Lim and Tan 2008; Gul et
al. 2013). In all our analyses, we discuss in detail the control variables and their predictions in an
online appendix (see Appendix B for the link). In addition, we winsorize continuous variables at the
top and bottom 1 percentiles to reduce the effect of outliers. Appendix A lists detailed variable
definitions.
In contrast to the passive role of the review partner, who only reviews the final audit reports,
the lead partner actively engages in an audit and has greater influences on the reporting quality. In
April 2003, Taiwan Stock Exchange and GreTai Securities Market, the two major stock exchanges
in Taiwan, adopted a set of rules that require listed companies to rotate their audit partners every
five years. The rules became fully effective in 2004.15 Using data prior to the mandatory rotation
rules, Chen et al. (2008) find that the partner with the longer continuous tenure with the client tends
to be the lead partner in the audit engagement. This practice changed around 2005 when it became
13
Following Kothari et al. (2005), our estimation of the modified Jones (1991) model is based on cross-sectional
regressions, and it slightly differs from the one used in Dechow et al. (1995), which is based on time-series
regressions. Kothari et al. (2005) argue that the approach in Dechow et al. (1995) is likely to generate large
measurement error whenever a firm experiences extreme growth.
14
Francis and Yu (2009) find that larger branch offices of audit firms provide higher audit quality in the U.S. We do not
include practice office fixed effects in Equation (2) for the following reasons. First, Taiwan is a small island and there
are limited branch offices besides the headquarters. Gul et al. (2013) indicate that branch offices conduct less than 5
percent of the audits in China, and we expect the percentage to be even lower in Taiwan. Because the headquarters
conducts the majority of the audits, our TEJ data source does not identify whether a particular audit was carried out by
a branch office. Moreover, since the clients of branch offices tend to be small local firms that are not traded, we do not
have the required financial data to run our fixed effect model. It is also unlikely that these firms will be in our capital
market tests. However, we recognize that a small number of partners may be working in the branch offices instead of
the headquarters. To the extent that these partners’ quality is positively correlated with the branch office quality, our
results may be picking up some branch office effect.
15
Although these rules are often referred to as ‘‘audit partner mandatory rotation rules’’ (e.g., Chi et al. 2009), the
rotation requirement is not strictly mandatory. Companies who do not comply with these rules are subject to an
investigation by the exchanges, and the exchanges can refer the noncompliant cases to the Financial Supervisory
Commission, the regulator for public accountants in Taiwan. The Commission will then send a written notice to the
noncompliant company and the audit firm to require the change of the audit partner. However, no fine or penalty will
be imposed.

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customary that the lead partner signs the audit report first.16 We follow Chen et al. (2008) and
define the lead partner as the partner who has the longest continuous tenure with the client for the
period of 1995–2005. For the period of 2006–2010, we define the lead partner as the first partner
signing the audit report.17
We estimate Equation (2) using the sample period from 1995–2005. Because of the inclusion
of firm fixed effects, the individual audit partner fixed effects can only be identified on firms that
have been audited by more than one partner over the estimation period. Following prior literature
(e.g., Bertrand and Schoar 2003), we further require each partner to work for at least two such
clients and have an average work experience at each client of at least three years.18 We multiply the
estimated fixed effects coefficients (di, hj, and cm) by 1, so higher fixed effects coefficients indicate
higher audit quality. To reduce measurement error and facilitate comparison of the partner, audit
firm, and client effects, we rank the transformed fixed effects coefficients into quartiles and denote
them as QPartnerFE, QAuditFirmFE, and QFirmFE.
We apply the fixed effect estimates using the sample period from 2006–2010 for the capital
market analyses. We include client fixed effect estimates (QFirmFE) in all our analyses, so that our
inferences on partner audit quality are conditional on the firm’s financial reporting quality. This
design is consistent with DeFond and Zhang (2014), who argue that audit quality should be
conditional on the client’s financial reporting system and innate characteristics. Since our interest is
in assessing the extent to which individual partners provide informational value to the capital
markets beyond the value provided by the audit firms, we also include audit firm fixed effect
estimates (QAuditFirmFE) in all our capital market analyses.
Table 1, Panel B presents descriptive statistics for our sample. The number of audit firms each
year is about 14. An audit firm, on average, has about 38 unique clients per year and ten lead
partners per year. Each lead partner, on average, has about four unique clients per year.
Estimation Results
Table 2, Panel A presents the summary statistics on the variables in Equation (2). ABSDA has a
mean value of 0.061 and a median value of 0.041, which are of similar magnitudes to the ones
documented in Chen et al. (2008). We find that, on average, 61.6 percent of the firm-years have
experienced a business model shock (BMS), consistent with Owens, Wu, and Zimmerman (2013),
who document that the majority of their sample has experienced business model shocks. On
average, an audit firm has an industry market share (IND_MKTSHARE_AF) of about 19 percent and
concentrates 7.6 percent of its client portfolio within the same industry (IND_PORTFOLIO_AF).
This pattern is reversed for engagement partners, who, on average, have an industry market share
(IND_MKTSHARE_EP) of about only 5 percent, but concentrate 20 percent of their client portfolio
within the same industry (IND_PORTFOLIO_EP). We also find that the Big N audit 80 percent of
our sample firms (Big N).
16
Private conversations with the Big 4 audit firms confirm that the lead partner tends to be the one that has the longer
tenure with the client prior to the adoption of the partner rotation rules and the practice changed around the adoption
of the new rules (2004/2005). Now, it is common practice that the lead partner signs the audit report first. We find that
in more than 80 percent of the cases in our sample, the first partner signing the report is also the one with the longest
continuous tenure with the client. However, this proportion goes down after 2005, thus confirming a change in the
definition of the lead partner around this time.
17
We perform additional validation tests on the measure of the lead partner in Section VII.
18
These requirements increase the precision of the partner effect estimates, because we ensure that each estimate is
based on at least six client firm-year observations. Stricter restrictions (e.g., each partner works for at least two clients
for at least five years) enhance precision, but also reduce sample sizes, which is problematic for the IPO and partner
change market reaction analyses. Both tests have small sample sizes to begin with. However, stricter restrictions
generally enhance our results on the ERC and debt contracting tests, both of which have large enough sample sizes.

November 2015
TABLE 2
Estimation of Individual Engagement Partner Quality
Panel A: Descriptive Statistics
Variable n Mean Std. Dev. p25 p50 p75
ABSDA 6,826 0.061 0.068 0.017 0.041 0.079
LOSS 6,826 0.097 0.296 0 0 0
LEVERAGE 6,826 0.274 0.189 0.118 0.270 0.407
TURNOVER 6,826 0.847 0.572 0.481 0.724 1.060
SIZE 6,826 8.393 1.292 7.473 8.237 9.116
BTM 6,826 1.000 1.015 0.492 0.777 1.233
AGE 6,826 23.203 11.442 14 22 31
CFO 6,826 0.085 0.114 0.027 0.071 0.130
STDCFO 6,826 0.091 0.101 0.037 0.062 0.108
BMS 6,826 0.616 0.486 0 1 1
TENURE_AF 6,826 7.791 4.814 3 7 11
IND_MKTSHARE_AF (%) 6,826 19.333 15.122 7.259 16.718 28.111
IND_PORTFOLIO_AF (%) 6,826 7.624 13.030 1.523 3.717 7.773
SIZE_AF 6,826 1.953 1.600 0.628 1.599 2.827
CI_AF 6,826 0.049 0.146 0.001 0.003 0.020
TENURE_EP 6,826 6.086 4.110 3 5 9
IND_MKTSHARE_EP (%) 6,826 4.990 7.765 0.713 1.807 5.544
IND_PORTFOLIO_EP (%) 6,826 20.762 24.814 3.041 9.946 29.180
SIZE_EP 6,826 0.080 0.107 0.014 0.035 0.106
CI_EP 6,826 0.279 0.307 0.046 0.144 0.416
Big N 6,826 0.800 0.400 1 1 1
Panel B: OLS Estimation of Engagement Partner Quality

Predicted Dependent
Sign Variable ¼ ABSDA
LOSS þ 0.003
[0.648]
LEVERAGE þ 0.026***
[2.347]
TURNOVER 0.004
[0.594]
SIZE 0.004
[0.960]
BTM 0.005***
[2.511]
AGE 0.001
[0.884]
CFO 0.020
[0.689]
STDCFO þ 0.098***
[3.837]
BMS þ 0.002
[1.165]
(continued on next page)

November 2015
TABLE 2 (continued)
Predicted Dependent
Sign Variable ¼ ABSDA
TENURE_AF 0.0004
[0.737]
IND_MKTSHARE_AF 0.0001
[1.080]
IND_PORTFOLIO_AF 0.001*
[1.588]
SIZE_AF 0.007**
[1.791]
CI_AF þ 0.068**
[1.983]
TENURE_EP 0.0004
[0.905]
IND_MKTSHARE_EP 0.0002
[0.885]
IND_PORTFOLIO_EP 0.0001*
[1.304]
SIZE_EP þ 0.024*
[1.544]
CI_EP þ 0.007
[0.962]
Year FE Yes
Engagement Partner FE Yes
Audit Firm FE Yes
Firm FE Yes
Observations 6,826
Adjusted R2 0.272
Joint significance of engagement partner FE: F-statistic ¼ 1.19, p-value , 0.01
***, **, * Represent a 1 percent, 5 percent, and 10 percent level of significance, respectively, based on one-tailed tests
for variables for which we predict an expected difference, and two-tailed tests for variables for which we do not predict
an expected difference.
This table presents the estimation of engagement partner quality using the methodology in Bertrand and Schoar (2003).
Panel A provides descriptive statistics. Panel B reports the estimation results. The estimation period is from 1995 to
2005. Reported in brackets are t-statistics calculated based on White heteroscedastic consistent standard errors and
adjusted for clustering by company.
See Appendix A for variable definitions.
Table 2, Panel B presents the regression results of Equation (2). The signs of the control
variables are generally consistent with prior studies.19 We find that the engagement partner effects
are jointly significant (F-statistic of 1.19, p-value , 0.01). To examine the extent to which partner
effects improve the model’s explanatory power, we follow previous studies (e.g., Collins, Maydew,
and Weiss 1997; Gul et al. 2013) and calculate the incremental R2 and the relative percentage
increase in R2 attributable to the engagement partners:
19
Some of the control variables are not significant. This is not surprising because we include firm fixed effects in the
model to control for firm heterogeneity. By including firm fixed effects, we are only exploiting variation within the
same firm over time. For variables that do not vary much over time (such as size, age, tenure), they will have large
standard errors, reducing their statistical significance.

November 2015
DR2 ¼ R2Full R2no EP

%R2 ¼ ðR2Full R2no EP Þ=R2no EP
where R2Full is the adjusted R2 of the full model including all fixed effects, and R2no EP is the adjusted
R2 of the model excluding partner fixed effects. Untabulated analysis shows that including
engagement partner effects increases the adjusted R2 of the model by 0.89 percent, with a
percentage increase of 3.38 percent. This increase in explanatory power is large compared to the
audit firm fixed effects. We find that including audit firm fixed effects only increases the adjusted
R2 of the model by 0.35 percent, with a percentage increase of 1.32 percent. Therefore, the
incremental explanatory power provided by individual audit partners is more than twice as large as
the incremental explanatory power provided by the audit firm. The finding that the individual
partner has a larger impact on audit quality than the audit firm is consistent with Gul et al. (2013).
Validation of Partner Fixed Effect Estimates

We conduct several analyses to validate our partner fixed effect estimates. To save space, we
do not tabulate these results; all results are available upon request. First, we perform a series of out-
of-sample tests using the sample period from 2006–2010. We find that client firms audited by
higher quality partners have smaller abnormal discretionary accruals. They are also less likely to
show benchmark beating behavior and to restate their financial statements. In addition, we find that
high quality partners are less likely to have received a regulatory sanction.20 These results provide
confidence that our estimates capture engagement partner quality.
V. EQUITY MARKET CONSEQUENCES
Earnings Response Coefficients (ERCs)

To examine the market’s perceptions of audit quality, we compare the ERCs between firms
audited by high quality partners and firms audited by low quality partners. The model takes the
form:
CAR ¼ a þ b1 SURPRISE þ b2 QPartnerFE þ b3 SURPRISE 3 QPartnerFE
þ b4 QAuditFirmFE þ b5 SURPRISE 3 QAuditFirmFE þ b6 QFirmFE
þ b7 SURPRISE 3 QFirmFE þ dX þ cSURPRISE 3 X þ e; ð3Þ
where CAR is the market-adjusted daily abnormal return accumulated over a three-day window
from one day before to one day after the earnings announcement date. SURPRISE is the earnings
surprise based on a seasonal random walk model and is equal to the seasonally differenced quarterly
earnings per share deflated by the stock price at the end of the quarter.21 We restrict our analysis to
the audited reports, that is, the second and fourth quarter earnings, as in Taiwan, semiannual reports
are audited no differently from annual reports.22 X is a vector of control variables that have been
shown to influence firms’ ERCs (e.g., Freeman and Tse 1992; Lim and Tan 2008; Dechow and You
20
Specifically, we run an ordered logit model and regress QPartnerFE on regulatory sanction history (SANCTION) and
a set of partner-specific control variables (i.e., gender, number of clients, whether the partner works for a Big N
accounting firm, whether the partner is an industry specialist, client importance, and client size). We find the
coefficient on SANCTION negative and significant.
21
We use the last year’s earnings in the same quarter to proxy for expected earnings because analyst following in
Taiwan is limited and we do not have analyst forecast data. From 2001 to 2008, only 18 percent of the Taiwanese
firms have analyst following (Lin, Chin, and Chang 2011). Therefore, it is reasonable to assume that investors rely on
the last year’s same-quarter earnings to form their expectations about the current quarter’s earnings.
22
Our results are robust to using all four quarters’ earnings and to using only annual earnings.

November 2015
2012). We interact the fixed effect estimates (QPartnerFE, QAuditFirmFE, and QFirmFE) and the
control variables with SURPRISE, because these variables are expected to affect the slope
coefficient on SURPRISE (the ERC). In all our capital market tests, we include year fixed effects to
control for unobserved time effects. Under the hypothesis that the market perceives financial reports
audited by high quality partners to be higher quality, we would expect b3 to be positive.
Table 3, Panel A reports the descriptive statistics. We have 6,289 firm-quarters for this
analysis. The average three-day CAR and earnings surprise are both close to zero. This result is not
surprising given that the returns are market-adjusted and we calculate earnings surprise based on a
random walk model.
Table 3, Panel B reports the regression results of Equation (3). For brevity, we suppress the
results on the control variables and present them in the online appendix for interested readers (see
Appendix B for the link). In column [1], we only include SURPRISE as the explanatory variable
and find that this variable is positively associated with the cumulative abnormal returns. We add the
three fixed effect estimates in column [2] and the full set of control variables in column [3]. In
column [4], we further include year and industry dummies and interact them with SURPRISE to
control for unobservable time and industry effects on ERC (Lim and Tan 2008; Balsam et al. 2003).
Regardless of the specifications, we find that earnings of firms audited by high quality partners are
valued higher than earnings of firms audited by low quality partners. The coefficients on the
interaction term SURPRISE 3 QPartnerFE are all positive and significant at the 5 percent level or
better across specifications.
The evidence in Table 3 indicates that when firms hire higher quality engagement partners to
conduct the audit, investors perceive the financial reports to be higher quality. If investors perceive
high quality partners to be valuable, then we would expect the market to react positively when a
firm switches from a low quality audit partner to a high quality audit partner. We investigate this
possibility in the next section.23
Market Reaction to Partner Changes

To examine whether the market reacts positively when a firm switches to a higher quality
partner, we conduct an event study and collect data on the announcement dates of partner changes
from 2006–2010. In Taiwan, public companies are required to make a public announcement within
two days when the board decides to change the audit firm or audit partner. The announcement
includes information on the old partners and audit firm, the new partners and audit firm, and the
reasons for the partner or audit firm change.24
23
We also run the ERC analysis using an alternative long-window association design (see Collins and Kothari 1989;
Ghosh and Moon 2005; Chi et al. 2009) and find robust results. Specifically, we regress CAR for the 16-month period
ending four months after the fiscal year-end on earnings (E), changes in earnings (DE), the fixed effect estimates, the
interactions of these variables, and a set of control variables. We find that the sum of the coefficients on E 3
QPartnerFE and DE 3 QPartnerFE is positive and significant. We also find that the increase in ERC mainly comes
from earnings changes (DE 3 QPartnerFE) as opposed to earnings levels (E 3 QPartnerFE). Given that the
coefficient on earnings changes captures the permanence of earnings (Ali and Zarowin 1992), this result suggests that
a high quality audit partner leads to higher earnings persistence as perceived by the market.
24
The Taiwan Stock Exchange Corporation Procedures for Verification and Disclosure of Material Information of
Companies with Listed Securities defines any change in audit partners and audit firms as a material event, and the
Taiwan Security Exchange Act, article 36-2, requires public disclosure of such an event within two days from the date
of occurrence. GreTai Securities Market (GTSM) adopts the same rules for firms traded in the OTC markets in the
GreTai Securities Market Procedures for Verification and Disclosure of Material Information of Companies with
GTSM Listed Securities. Companies are not required to file a specific filing for partner and audit firm changes, but
they need to make an announcement at the MOPS. The announcement typically includes the reasons for the partner
and audit firm change; however, the descriptions of the reasons are usually very vague.

November 2015
TABLE 3
ERC Analysis

CAR 6,289 0.00 0.05 0.03 0.01 0.02
SURPRISE 6,289 0.00 0.11 0.03 0.00 0.03
QPartnerFE 6,289 1.16 1.03 0 1 2
QAuditFirmFE 6,289 1.69 0.86 1 1 3
QFirmFE 6,289 1.51 1.12 0 2 3
PERSIST 6,289 0.27 0.25 0.07 0.28 0.47
BETA 6,289 0.83 0.35 0.59 0.86 1.08
BTM 6,289 0.85 0.53 0.48 0.73 1.08
STDRET 6,289 2.63 0.84 2.02 2.59 3.19
LEVERAGE 6,289 0.37 0.16 0.25 0.36 0.47
SIZE 6,289 15.25 1.38 14.29 15.05 15.99
LOSS 6,289 0.22 0.41 0 0 0
Q4 6,289 0.50 0.50 0 1 1
Panel B: ERC Regression Results

Dependent Variable ¼ 3-day CAR (1, þ1)
Predicted
Sign [1] [2] [3] [4]
SURPRISE þ 0.060*** 0.014 0.045 0.048
[8.613] [0.272] [0.484] [0.381]
QPartnerFE þ/ 0.001 0.001 0.001
[1.513] [1.021] [1.409]
SURPRISE 3 QPartnerFE þ 0.018** 0.016** 0.018**
[2.186] [1.831] [1.928]
QFirmFE þ/ 0.000 0.001 0.001
[0.355] [1.592] [1.303]
SURPRISE 3 QFirmFE þ 0.004 0.004 0.000
[0.543] [0.645] [0.009]
QAuditFirmFE þ/ 0.001 0.001 0.001
[0.540] [0.528] [0.763]
SURPRISE 3 QAuditFirmFE þ 0.016* 0.010 0.012
[1.388] [0.892] [0.970]
Constant 0.004*** 0.008 0.004
[5.848] [1.471] [0.431]
Controls No No Yes Yes
Controls 3 SURPRISE No No Yes Yes
Year FE No No No Yes
Year FE 3 SURPRISE No No No Yes
Industry FE No No No Yes
Industry FE 3 SURPRISE No No No Yes
Observations 6,289 6,289 6,289 6,289
Adjusted R2 0.020 0.022 0.053 0.079

November 2015
TABLE 3 (continued)
This table uses an ERC analysis to examine whether investors perceive earnings audited by higher quality partners to be
more informative. Panel A reports descriptive statistics and Panel B reports the regression results. The sample period is
from 2006–2010. For brevity, the results on the control variables are not reported, but are available in the online
appendix (see Appendix B for the link). Reported in brackets are t-statistics calculated based on White heteroscedastic
consistent standard errors and adjusted for clustering by firm.
We restrict our sample to firms changing the lead partners, as lead partners are the ones most
likely to influence audit quality. We exclude announcements made outside the two-day window
from the board meeting, as we are unable to identify the date the market learns the news. Such late
announcements happen when the firm does not comply with the regulatory requirement. Our
empirical model takes the form:
CAR ¼ a þ b1 ChgQPartnerFE þ b2 ChgQAuditFirmFE þ b3 DChgAuditFirm þ dX þ e; ð4Þ
where CAR is the cumulative abnormal returns around the announcement date. The Taiwan stock
markets impose a 7 percent single-day price limit (up and down 7 percent), except for the first five
trading days of an IPO. Prior research shows that imposing a price limit may lead to less efficient
price discovery (Kim and Rhee 1997). Therefore, we examine market reactions over various short
windows: (1, þ1), (1, þ2), and (2, þ2), as well as a relatively longer window (1, þ10) to
account for any delayed response.25 ChgQPartnerFE is the change in QPartnerFE for the lead
partner, where a positive value indicates hiring a higher quality audit partner. We also use an
alternative measure of changes in partner quality when the company replaces both the lead and
review partners at the same time, defining ChgQPartnerFE as the sum of the changes in
QPartnerFE for both partners. We conduct the analysis using both definitions of ChgQPartnerFE,
because in cases of changes in both partners, it is unclear whether the market can recognize who the
future lead partner is at the time of the announcement.26 Often, when a firm changes the partner, it
also changes the audit firm. To ensure that our results are not driven by the change in audit firm
quality, we control for the change in audit firms. DChgAuditFirm is an indicator variable equal to 1
if the firm changes the accounting firm, and 0 otherwise. ChgQAuditFirmFE is the change in
QAuditFirmFE for firms hiring a new audit firm, and 0 for firms retaining the same audit firm. X is a
vector of control variables, including a battery of variables controlling for potential confounding
events concurrent with the announcements.
Table 4, Panel A reports the descriptive statistics. We have 117 observations for this analysis.
Regardless of how we define the variable, the median value of ChgQPartnerFE is 0, suggesting that
the majority of the new hire partners are of similar quality as the old partners. The median values of
other potential confounding events (earnings announcements and announcements related to
executive turnover, dividend payouts, capital raising, and restatements) are 0, with mean values all
below 10 percent. This suggests that other events not directly related to the change of partners are
unlikely to confound our results.
25
We also find consistent results for other windows such as (1, þ5) and (1, þ20).
26
One third of the sample (39 observations) changes both the lead and review partners at the same time.

November 2015
TABLE 4
Market Reaction to Partner Changes
November 2015
CAR (1, þ1) 117 0.004 0.054 0.024 0.001 0.028

CAR (1, þ2) 117 0.002 0.062 0.033 0.002 0.031
CAR (2, þ2) 117 0.006 0.070 0.032 0.004 0.029
CAR (1, þ10) 117 0.002 0.079 0.051 0.001 0.045
ChgQPartnerFE (Lead partner) 117 0.10 1.03 1 0 0
ChgQPartnerFE (Both partners) 117 0.09 1.58 1 0 1
ChgQAuditFirmFE 117 0.06 0.65 0 0 0
DChgAuditFirm 117 0.21 0.41 0 0 0
OTC 117 0.49 0.50 0 0 1
EA 117 0.05 0.22 0 0 0
ChgExec 117 0.07 0.25 0 0 0
DivAnn 117 0.10 0.30 0 0 0
Capital Market Consequences of Audit Partner Quality
CapitalRaising 117 0.03 0.16 0 0 0

RestatementAnn 117 0.01 0.09 0 0 0
LOSS 117 0.18 0.39 0 0 0
LEVERAGE 117 0.37 0.17 0.23 0.37 0.49
BTM 117 0.75 0.45 0.43 0.67 0.93
SIZE 117 14.92 1.43 13.98 14.65 15.47
2159
TABLE 4 (continued)
2160
Panel B: Regression Results on the Market Reactions to Partner Changes

Change in Lead Partner Quality Change in Both Partners’ Quality
Predicted CAR CAR CAR CAR CAR CAR CAR CAR
Sign (1, þ1) (1, þ2) (2, þ2) (1, þ10) (1, þ1) (1, þ2) (2, þ2) (1, þ10)
ChgQPartnerFE þ 0.007 0.009* 0.009** 0.012* 0.004 0.007** 0.007** 0.011**
[1.275] [1.586] [1.813] [1.408] [1.027] [1.860] [1.923] [1.734]
ChgQAuditFirmFE þ 0.010 0.008 0.010 0.014 0.009 0.005 0.006 0.021
[0.816] [0.937] [1.182] [1.130] [0.762] [0.457] [0.572] [1.320]
DChgAuditFirm þ/ 0.000 0.000 0.003 0.019 0.000 0.001 0.004 0.020
[0.008] [0.020] [0.210] [0.879] [0.021] [0.064] [0.260] [0.942]
OTC þ/ 0.016 0.018 0.026 0.012 0.015 0.017 0.026 0.012
[1.409] [1.010] [1.417] [0.471] [1.354] [1.021] [1.422] [0.490]
EA þ/ 0.003 0.010 0.009 0.048 0.004 0.007 0.006 0.043
[0.107] [0.444] [0.409] [1.633] [0.157] [0.338] [0.289] [1.550]
ChgExec þ/ 0.021 0.017 0.038** 0.075** 0.020 0.016 0.037** 0.074**
[1.136] [0.844] [2.055] [2.713] [1.024] [0.776] [1.904] [2.574]
DivAnn þ 0.030** 0.025* 0.058** 0.002 0.032*** 0.027** 0.060** 0.004
[2.092] [1.482] [2.165] [0.109] [2.589] [1.772] [2.416] [0.209]
CapitalRaising þ/ 0.013 0.039 0.055 0.035 0.008 0.031 0.047 0.023
[0.221] [0.702] [0.781] [0.847] [0.134] [0.580] [0.690] [0.533]
RestatementAnn 0.008 0.074*** 0.050** 0.065** 0.014 0.079*** 0.056*** 0.071***
[0.319] [2.541] [2.004] [2.457] [0.568] [3.032] [2.781] [2.924]
LOSS þ/ 0.014 0.028 0.034 0.001 0.014 0.026 0.032 0.001
[0.690] [1.196] [1.499] [0.050] [0.667] [1.109] [1.383] [0.050]
LEVERAGE 0.016 0.010 0.008 0.000 0.013 0.012 0.010 0.001
[0.485] [0.283] [0.198] [0.011] [0.401] [0.352] [0.256] [0.031]
BTM þ/ 0.025* 0.024 0.032** 0.000 0.025* 0.025 0.033** 0.002
[1.991] [1.518] [2.070] [0.018] [1.959] [1.655] [2.148] [0.090]
SIZE þ/ 0.006* 0.007** 0.010** 0.003 0.006* 0.007** 0.009** 0.003
[2.072] [2.318] [2.445] [0.730] [1.876] [2.167] [2.310] [0.669]
Aobdia, Lin, and Petacchi
November 2015
TABLE 4 (continued)
Change in Lead Partner Quality Change in Both Partners’ Quality
Predicted CAR CAR CAR CAR CAR CAR CAR CAR
Sign (1, þ1) (1, þ2) (2, þ2) (1, þ10) (1, þ1) (1, þ2) (2, þ2) (1, þ10)
November 2015
Year FE Yes Yes Yes Yes Yes Yes Yes Yes
Observations 117 117 117 117 117 117 117 117

R2 0.126 0.180 0.256 0.117 0.120 0.181 0.257 0.125
***, **, * Represent a 1 percent, 5 percent, and 10 percent level of significance, respectively, based on one-tailed tests for variables for which we predict an expected difference,
and two-tailed tests for variables for which we do not predict an expected difference.
This table examines the market reaction to the announcement of a partner change. Panel A reports descriptive statistics. Panel B reports the regression results. The sample period is
from 2006 to 2010. Reported in brackets are t-statistics calculated based on White heteroscedastic consistent standard errors and adjusted for clustering by quarter.
2161
Table 4, Panel B reports the results of Equation (4). In general, we find that the market reacts
positively to the announcement of the partner change when the new partner is of higher quality than
the old partner. The coefficient on ChgQPartnerFE is positive and significant across various
windows, except for (1, þ1), where the coefficient remains positive, but insignificant. The
magnitude of the coefficient suggests that a one-quartile increase in partner quality is associated
with a market reaction ranging from 0.7 percent to 1.2 percent, depending on the measurement
window. These results are consistent with investors in the equity market viewing individual audit
partners as a relevant factor in determining the quality of corporate financial reporting.27
Initial Public Offerings Underpricing

In this section, we explore whether partner quality affects IPO underpricing. Our model takes
the form:
UP ¼ a þ b1 QPartnerFE þ b2 QAuditFirmFE þ dX þ e; ð5Þ
where UP is the level of underpricing, computed as the one-day buy and hold return of the stock
(price at the end of the first trading day deflated by offering price minus one). Since the IPO
markets in developing countries may be less efficient,28 we also estimate UP as the buy and hold
return over the first three and 20 trading days. X is a vector of control variables that have been
shown to influence IPO underpricing (e.g., Beatty 1989; Leone, Rock, and Willenborg 2007; Peng
and Wang 2007). We also include underwriter fixed effects to control for the underwriter prestige
and reputation. We test Equation (5) using IPO data from 2006 to 2010. Under the hypothesis that
hiring a higher quality audit partner serves as a positive signal and leads to a reduction in the
underpricing discount, we expect b1 to be negative.29
Table 5, Panel A reports the descriptive statistics. We have 146 observations for this analysis.
The median one-day, three-day, and 20-day returns are high at around 35 percent, suggesting that
most IPOs in our sample period are heavily underpriced. The large underpricing in the Taiwan IPO
market is consistent with prior research (Loughran et al. 1994; Peng and Wang 2007; Lu, Kao, and
Chen 2012).30 The median age of the companies is 11 years and the median book-to-market ratio
(BTM) is below 0.50. These results suggest that IPO firms during the period of 2006–2010 were
relatively young and with high growth opportunities.
Table 5, Panel B presents the results of Equation (5). Column [1] shows that IPO firms who
employ higher quality engagement partners experience less underpricing. The magnitude of the
coefficient on QPartnerFE suggests that a one-quartile increase in partner quality is associated with
a 7.7 percent reduction in the first-day returns. In column [2], we include underwriter dummies to
27
Although we have included an extensive set of concurrent announcements to control for potential confounding events,
as in any event study, we cannot completely rule out the possibility that some other events we do not control for are
driving the results. Therefore, we caution the interpretation of the results.
28
For example, Loughran, Ritter, and Rydqvist (1994, Table 1) show that the IPO underpricing for developing countries
such as Brazil, Korea, and Taiwan is above 45 percent, while developed countries such as Canada, France, and The
Netherlands are below 10 percent.
29
In contrast to other specifications, we cannot include QFirmFE as an explanatory variable in Equation (5) because this
variable cannot be estimated during the estimation period, which occurred prior to the firms’ IPOs.
30
Our underpricing descriptives are higher than Peng and Wang (2007) and Lu et al. (2012), both of which show an
underpricing mean value of about 20 percent. This difference is likely due to differences in sample periods. Both Peng
and Wang (2007) and Lu et al. (2012) use sample periods before 2005, while we use a sample period from 2006–
2010. Taiwan stock exchanges imposed a 7 percent price limit and this limit was lifted in 2005 for the first five trading
days of an IPO. Moreover, we find that IPO firms during 2006–2010 concentrate in growth industries (e.g.,
semiconductor, optoelectronic), whereas IPO firms during 1985–2005 concentrate in mature industries (e.g.,
construction). Using the data from 1985–2005, we find that the median three-day return is 16.8 percent and the 20-day
return is 14.4 percent. These figures are comparable to Peng and Wang (2007) and Lu et al. (2012).

November 2015
TABLE 5
IPO Underpricing Analysis

UP 1-DAY 146 0.56 0.51 0.19 0.37 0.82
MKTRET 1-DAY 146 0.00 0.01 0.01 0.00 0.01
UP 3-DAYS 146 0.52 0.47 0.18 0.35 0.82
MKTRET 3-DAYS 146 0.00 0.03 0.02 0.00 0.01
UP 20-DAYS 146 0.59 0.67 0.15 0.36 0.87
MKTRET 20-DAYS 146 0.01 0.07 0.04 0.01 0.05
LOSS 146 0.01 0.08 0 0 0
LEVERAGE 146 0.17 0.17 0 0 0
ELEC 146 0.86 0.35 1 1 1
AGE 146 13.86 9.33 7 11 18
ABSDA 146 0.08 0.09 0.02 0.05 0.11
FM 146 0.01 0.08 0 0 0
OTC 146 0.66 0.47 0 1 1
SIZE 146 14.40 1.03 13.69 14.23 14.95
SUCCESS 146 3.81 10.47 0.84 1.76 2.90
MKTRET48 146 0.04 0.11 0.04 0.05 0.09
STDMKTRET48 146 1.35 0.50 0.94 1.32 1.67
QPartnerFE 146 2.31 0.92 2 2 3
QAuditFirmFE 146 2.51 0.79 2 2 3
IPOSIZE 146 12.44 1.06 11.57 12.40 13.09
FLOAT 146 0.10 0.02 0.09 0.10 0.11
BTM 146 0.50 0.31 0.26 0.43 0.73
Panel B: Regression Results on the Relation between IPO Underpricing and Engagement
Partner Quality
Dependent Variable Dependent Variable Dependent Variable
¼ UP-1 DAY ¼ UP-3 DAYS ¼ UP-20 DAYS
Pred.
Sign [1] [2] [3] [4] [5] [6]
QPartnerFE 0.077*** 0.077** 0.074*** 0.069** 0.115** 0.104**
[2.552] [2.137] [2.694] [1.969] [2.130] [2.276]
QAuditFirmFE 0.027 0.026 0.053* 0.053 0.060 0.051
[0.596] [0.456] [1.660] [1.264] [0.848] [0.697]
LOSS þ 0.208 0.041 0.254 0.178 0.004 0.060
[0.832] [0.150] [1.035] [0.633] [0.013] [0.177]
LEVERAGE þ 0.037 0.021 0.164 0.087 0.354 0.484
[0.114] [0.052] [0.534] [0.235] [0.956] [0.902]
ELEC þ 0.040 0.006 0.018 0.062 0.019 0.083
[0.392] [0.053] [0.178] [0.518] [0.138] [0.459]
AGE 0.008** 0.004 0.007* 0.004 0.012* 0.007
[1.854] [1.004] [1.398] [0.770] [1.453] [0.948]
ABSDA þ 0.704 0.878* 0.397 0.444 0.513 0.430
[1.201] [1.354] [0.778] [0.700] [0.753] [0.537]
FM 1.781*** 1.849*** 1.295*** 1.382*** 1.451*** 1.643***
[4.716] [4.749] [4.380] [4.324] [2.883] [2.993]

November 2015
TABLE 5 (continued)
Dependent Variable Dependent Variable Dependent Variable
¼ UP-1 DAY ¼ UP-3 DAYS ¼ UP-20 DAYS
Pred.
Sign [1] [2] [3] [4] [5] [6]
OTC þ 0.064 0.112 0.045 0.121 0.082 0.174
[0.434] [0.645] [0.373] [0.782] [0.534] [0.987]
SIZE 0.148 0.110 0.094 0.049 0.119 0.049
[1.010] [0.700] [0.657] [0.319] [0.470] [0.197]
SUCCESS 0.005* 0.007** 0.004* 0.005* 0.003 0.004
[1.414] [1.805] [1.403] [1.551] [0.831] [1.089]
MKTRET48 þ 1.362*** 1.544*** 1.184*** 1.397*** 1.504*** 1.702***
[2.795] [3.268] [3.003] [3.615] [3.662] [5.029]
STDMKTRET48 þ 0.262* 0.197 0.203 0.117 0.287 0.165
[1.334] [0.960] [1.229] [0.664] [1.223] [0.762]
MKTRET þ 6.124** 7.356*** 2.270* 2.869** 2.099* 2.193**
[2.466] [3.404] [1.364] [1.799] [1.726] [2.175]
IPOSIZE 0.008 0.012 0.021 0.055 0.005 0.064
[0.058] [0.079] [0.161] [0.400] [0.018] [0.247]
FLOAT 2.301 2.418 0.679 1.174 1.580 1.848
[1.024] [0.961] [0.342] [0.487] [0.376] [0.439]
BTM 0.094 0.024 0.049 0.201 0.141 0.122
[0.335] [0.080] [0.172] [0.664] [0.320] [0.243]
Year FE Yes Yes Yes Yes Yes Yes
Underwriter FE No Yes No Yes No Yes
Observations 146 146 146 146 146 146
Adjusted R2 0.249 0.223 0.233 0.201 0.158 0.134
This table examines the association between the quality of the engagement partner and IPO underpricing. Panel A reports
descriptive statistics and Panel B reports the regression results. The sample period is from 2006 to 2010. Reported in
brackets are t-statistics calculated based on White heteroscedastic consistent standard errors and adjusted for clustering
by quarter.
control for the effect of underwriter reputation on IPO underpricing. We find that the coefficient on
QPartnerFE remains significant and has the same magnitude as the coefficient in column [1]. In
columns [3] to [6], we repeat the analysis using three-day and 20-day returns to measure
underpricing and find consistent results. In particular, a one-quartile increase in partner quality is
associated with an approximately 7 percent reduction in the first three-day returns and an
approximately 10 percent reduction in the first 20-day returns. Overall, these results are consistent
with the hypothesis that when the value of the firm is imperfectly known, hiring a high quality
engagement partner serves as a positive signal to the investors.
VI. DEBT MARKET CONSEQUENCES

To examine whether partner quality matters to the debt market participants, we investigate
whether firms audited by higher quality partners enjoy more favorable terms in their debt contracts.
For this analysis, we focus on the private debt market because the public bond market is still not
well developed in Taiwan. Only government enterprises and some large corporations raise capital in

November 2015
the bond markets. Moreover, the market becomes largely inactive after 2005 and once imposing
additional data requirements, we can only obtain limited bond issuances (about 75 observations) for
our testing period of 2006–2010.31
We use the following model to investigate the impact of audit partner quality on debt
contracting:
Contract Term ¼ a þ b1 QPartnerFE þ b2 QAuditFirmFE þ b3 QFirmFE þ dX þ e: ð6Þ
We examine both price and non-price contract terms. The price term is the interest rate charged on
the loan (INTEREST RATE).32 The non-price terms are the borrowing amount (Log(AMOUNT))
and whether the loan requires collateral (SECURED). We use the borrowing amount to examine
whether partner quality affects firms’ credit access and the security requirement to examine whether
partner quality affects contract stringency.33 When the dependent variables are INTEREST RATE
and Log(AMOUNT), we estimate Equation (6) using an ordinary least squares (OLS) model, and
when the dependent variable is SECURED, we estimate the equation using a logit model. X is a
vector of control variables that have been found in prior literature to influence debt contracting (e.g.,
Petersen and Rajan 1994; Graham, Li, and Qiu 2008; Bharath et al. 2008). We also include industry
fixed effects to control for unobserved industry heterogeneity. To ensure that lenders observe the
attributes of the engagement partner, we match the debt contract with the most recent annual report,
which is the report most likely to be used in the loan application process. Since contract terms vary
across facilities of a given loan deal, we conduct our analysis at the facility level. Our hypothesis
predicts b1 to be negative when the dependent variable is either INTEREST RATE or SECURED,
and positive when the dependent variable is Log(AMOUNT) (i.e., lower interest rates, less
likelihood of requiring security, and larger credit access for firms audited by higher quality
partners).
Table 6, Panel A provides descriptive statistics on the variables. We have 9,079 facilities
representing 6,976 loan deals and 1,513 firm-years for this analysis. The average interest rate
charged on the loan is 2.52 percent, the average borrowing amount is about NT49 million, and
about 43 percent of the loans require collateral. The average lending relationship (LENGTHREL) is
about seven years and, in contrast to the U.S. loan market, most of the loans in Taiwan are not
syndicated.
Table 6, Panel B reports the results of Equation (6). Columns [1] and [2] show that
QPartnerFE is negatively associated with the loan rate, suggesting that firms can lower their
borrowing costs by hiring high quality audit partners. A one-quartile increase in partner quality is
associated with an approximate six-basis-point reduction in borrowing rate. Columns [3] and [4]
report a positive association between audit partner quality and borrowing amount, suggesting that
31
The Taiwanese bond market has become inactive since 2005 for the following reasons. First, a few large investors,
with better resources and information processing capabilities, have driven small retail investors away. In addition,
only limited hedging vehicles are available to hedge interest rate risk, and the trading activities in these vehicles have
also declined after 2005. Therefore, it has become difficult to hedge interest rate risk. Finally, the Taiwan government
imposes a relatively high tax rate (20 percent) on bond investments. All these factors have led to low demand in the
bond market.
32
All the interest rates in our sample are fixed rates. We exclude loans with variable rates because in Taiwan, companies
do not disclose the specific spread charged on the loan; instead, they only disclose a range of the rates. The range
tends to be wide and imprecise. The majority (71 percent in our sample) of the loans initiated from 2006–2010 are
also fixed rate loans. This feature is distinct from the private debt market in the U.S. Our results remain robust (albeit
slightly weaker) when including variable rate loans and assuming that the interest rate is the average of the range of
the rates disclosed.
33
In Taiwan, companies are not required to publicly file their debt contracts, so detailed information on debt contract
terms (e.g., covenant restrictions) is unavailable. However, the financial statements list each loan’s collateral
requirement. Therefore, we use collateral requirement to proxy for debt contract stringency.

November 2015
TABLE 6
2166
Debt Contract Analysis

QPartnerFE 9,079 2.28 0.96 2 2 3
QAuditFirmFE 9,079 2.53 0.74 2 2 3
QFirmFE 9,079 2.48 1.12 1 2 3
INTEREST RATE 9,079 2.52 1.30 1.72 2.43 2.97
TIBOR 9,079 1.17 0.81 0.23 1.59 2.00
Log(AMOUNT) 9,079 10.80 1.59 9.90 10.82 11.76
SECURED 9,079 0.43 0.50 0 0 1
LENGTHREL 9,079 2,582 2,262 583 2,008 4,270
SYNDICATION 9,079 0.07 0.25 0 0 0
Log(MATURITY) 9,079 5.35 1.30 4.50 5.20 6.31
OHLSON 9,079 4.76 1.07 5.56 4.74 3.96
EBITDA 9,079 0.10 0.06 0.06 0.09 0.13
STDCFO 9,079 0.07 0.07 0.03 0.05 0.08
CURRENT 9,079 1.51 0.73 1.10 1.36 1.77
SIZE 9,079 15.85 1.52 14.72 15.59 16.88
BTM 9,079 1.16 0.73 0.64 0.98 1.50
TANGIBILITY 9,079 0.34 0.17 0.22 0.34 0.46
LEVERAGE 9,079 0.36 0.16 0.25 0.38 0.46
JUNK 9,079 0.63 0.48 0 1 1
NO RATING 9,079 0.00 0.03 0 0 0

November 2015
TABLE 6 (continued)
Panel B: Regression Results on the Relation between Debt Contract Terms and Engagement Partner Quality
Dependent Variable ¼ Dependent Variable ¼ Dependent Variable ¼
INTEREST RATE Log(AMOUNT) SECURED
November 2015
Pred. Pred. Pred.
Sign [1] [2] Sign [3] [4] Sign [5] [6]

QPartnerFE 0.065** 0.058* þ 0.139*** 0.192*** 0.191*** 0.167**
[1.824] [1.641] [3.142] [4.228] [2.361] [2.060]
QAuditFirmFE 0.008 0.022 þ 0.144*** 0.168*** 0.169** 0.169**
[0.169] [0.485] [2.981] [3.540] [1.925] [1.927]
QFirmFE 0.042* 0.018 þ 0.044* 0.099*** 0.199*** 0.146***
[1.618] [0.681] [1.517] [3.253] [3.097] [2.363]
TIBOR þ 0.158*** 0.140***
[2.825] [2.680]
LENGTHREL 0.000*** 0.000*** þ 0.000 0.000 þ/ 0.000*** 0.000***
[3.508] [2.716] [0.030] [0.203] [5.971] [5.819]
SYNDICATION þ/ 0.098 0.092 þ 0.177 0.275* þ 0.152 0.872***

[1.122] [0.915] [1.100] [1.324] [0.318] [2.685]
Log(MATURITY) þ 0.129*** 0.122*** þ 0.178*** 0.153*** þ 0.263*** 0.261***
[6.797] [6.553] [9.674] [8.742] [5.931] [6.583]
Log(AMOUNT) 0.173*** 0.176*** þ 0.077** 0.049*
[7.330] [8.171] [1.894] [1.305]
SECURED þ 0.203*** 0.181*** þ 0.120** 0.079*
[3.423] [3.236] [2.060] [1.504]
OHLSON þ 0.202*** 0.200*** 0.160*** 0.192*** þ 0.175* 0.105
[4.147] [4.346] [2.709] [3.498] [1.510] [0.885]
EBITDA 0.677* 0.400 þ 1.488*** 0.952** 0.867 0.399
[1.398] [0.845] [2.842] [1.941] [0.878] [0.385]
STDCFO þ 0.541* 0.459 1.155*** 1.158*** þ 0.649 0.173
[1.301] [0.986] [2.413] [2.477] [0.767] [0.210]
CURRENT 0.051 0.062* þ 0.075** 0.105*** 0.057 0.127
[0.986] [1.603] [1.651] [2.372] [0.507] [1.264]
2167
TABLE 6 (continued)
2168
Dependent Variable ¼ Dependent Variable ¼ Dependent Variable ¼

INTEREST RATE Log(AMOUNT) SECURED
Pred. Pred. Pred.
Sign [1] [2] Sign [3] [4] Sign [5] [6]
SIZE 0.098*** 0.081*** þ 0.632*** 0.570*** 0.394*** 0.444***
[2.804] [2.542] [18.343] [18.598] [5.645] [6.506]
BTM þ 0.140*** 0.185*** 0.257*** 0.205*** þ 0.282*** 0.355***
[2.555] [3.551] [3.759] [3.246] [2.965] [3.944]
TANGIBILITY 0.232* 0.045 þ 0.422** 0.169 0.303 0.822**
[1.308] [0.248] [2.145] [0.730] [0.771] [1.867]
LEVERAGE þ 0.421* 0.500** 0.121 0.171 þ 1.598*** 1.198**
[1.359] [1.659] [0.412] [0.599] [2.659] [1.942]
JUNK þ 0.148* 0.092 0.112 0.048 þ 0.485*** 0.330**
[1.629] [1.051] [1.247] [0.584] [2.716] [2.031]
NO RATING þ/ 0.398 0.581** þ/ 0.526 0.462 þ 1.699*** 1.231**
[1.229] [2.120] [1.617] [0.985] [4.924] [1.738]
Year FE Yes Yes Yes Yes Yes Yes
Industry FE No Yes No Yes No Yes
Observations 9,079 9,079 9,079 9,079 9,079 9,079
Adjusted R2 0.416 0.437 0.427 0.449 0.102 0.145
***, **, * Represent a 1 percent, 5 percent, and 10 percent level of significance, respectively, based on one-tailed tests for variables for which we predict an expected difference,
and two-tailed tests for variables for which we do not predict an expected difference.
This table investigates whether firms audited by higher quality partners can obtain better loan contract terms. Panel A reports descriptive statistics and Panel B reports the regression
results. The sample period is from 2006 to 2010. Reported in brackets are t- or z-statistics calculated based on White heteroscedastic consistent standard errors and adjusted for
clustering by firm-year.
November 2015
by hiring a high quality audit partner, firms can have larger credit access to the private debt market.
In particular, a one-quartile increase in audit partner quality is associated with an approximate 14
percent to 19 percent increase in borrowing amount. Finally, columns [5] and [6] show that
engagement partner quality is negatively associated with collateral requirement. We also find that
audit firm quality and the company’s financial reporting quality are generally positively associated
with more favorable debt contract terms.
Overall, Table 6 provides evidence that engaging a high quality audit partner is associated with
a reduction in borrowing costs, an increase in credit access, and less stringent contract terms.
Importantly, we control for audit firm quality; therefore, our evidence suggests that an individual
partner can enhance the credibility of financial statements and reduce information asymmetry
between the borrower and the creditor beyond the reputation effect of the audit firm.
VII. ADDITIONAL ANALYSES AND ROBUSTNESS TESTS
Determination of the Lead Partner

To validate that it is the lead partner that affects audit quality and that our procedure for
identifying the lead partner is sufficiently precise, we run two additional analyses. First, we add
review partner fixed effects and their control variables in Equation (2). Despite the inclusion of
many more fixed effects, we do not find an increase in the adjusted R2 of the model.34 This result
suggests that in Taiwan, the review partner has little influence on audit quality and is consistent
with Chi and Chin (2011), who conclude that review partners alone are not associated with higher
audit quality.
Second, we rerun all our capital markets tests on the review partner instead of the lead partner.
If review partners only rubber-stamp the audit reports, then we would not expect market
participants to respond to the quality of the review partner.35 Consistent with the expectation, we
find no association between the estimated review partner quality and capital markets effects, except
for the debt analysis, where in some specifications, we observe a weak association between review
partner quality and debt pricing and amount. The lack of results on review partners provides support
that it is the lead partner that affects audit quality and elicits capital market consequences.
Results on Signed Accruals

To explore whether the market participants value partner quality differently based on whether
the partner constrains income-increasing accruals or income-decreasing accruals, we rerun Equation
(2) separately with positive DA and negative DA as the dependent variables.36 However, this design
greatly reduces our sample size due to the identification restriction we need to impose on the fixed
effect estimates (see discussion in Section IV). This issue is especially problematic for our IPO and
partner change analyses, both of which have small sample sizes. For example, for the partner
change analysis, our sample size reduces to only 32 (46) observations when we estimate the partner
fixed effects using positive (negative) DA. Given that we have more than ten control variables in
34
The adjusted R2 actually slightly decreases from 27.2 percent to 27 percent.
35
We thank the referees for suggesting this analysis.
36
This research design is consistent with Myers et al. (2003) and Francis and Yu (2009). We do not use DA as the
dependent variable without partitioning the variable into positive and negative values, because accrual-based earnings
management reverses over time (Dechow et al. 2012). When running a panel dataset, this reversal behavior cancels
out positive accruals against negative accruals. Since the fixed effects estimates capture the average DA, we may
incorrectly conclude that a partner fixed effects estimate close to zero indicates no earnings management, which, in
fact, has large income-increasing accruals canceled out by large income-decreasing accruals due to reversal.

November 2015
these tests, running a regression on such small sample sizes reduces statistical power and precision.
Therefore, we focus on the ERC and debt analyses for the signed accrual tests.
For the ERC analysis, our results hold using partner fixed effect estimates measured under both
positive DA and negative DA under the long-window association design (see the design in footnote
23). Under the short-window design of Equation (3), the results are significant for negative DA, but
not for positive DA. Collectively, the findings suggest that investors perceive earnings to be more
informative when the engagement partner constrains both income-increasing and income-
decreasing accruals, consistent with prior findings that higher audit quality curbs both upward
and downward earnings management (e.g., Myers et al. 2003; Francis and Yu 2009). For the debt
analysis, our results are mixed. We find that companies enjoy a greater credit access when they hire
partners constraining either income-increasing accruals or income-decreasing accruals. Companies
are less likely to be required to post collateral when they hire partners constraining income-
increasing accruals. We do not find results on loan rates when we separate out income-increasing
accruals from income-decreasing accruals. Overall, these results suggest that lenders are more likely
to care about the magnitude of the accruals than the sign of the accruals and are consistent with
Bharath et al. (2008, 4), who find that ‘‘both public and private debt lenders appear to factor in the
magnitude of operating accruals rather than the sign of the accruals in setting debt contract terms.’’
An Alternative Proxy for Partner Quality

We use regulatory sanctions as an alternative proxy for partner quality. A regulatory sanction
case in Taiwan usually represents outright fraud or involves a serious accounting irregularity.
Sanctioned partners are typically warned, suspended, or have their license revoked. Because these
regulatory actions are public information, a sanctioned partner is deemed as low quality by capital
market participants. Although free from measurement error, a sanction is uncommon, which greatly
reduces variation among partners and biases against us finding results. However, we still find a
significantly positive market reaction when a company replaces a partner with a history of
regulatory sanctions with a partner without such a history. Further, we find that firms audited by
partners with a regulatory sanction history pay higher interest rates on their loans.
VIII. CONCLUSION
This study responds to the call for more academic research on individual auditors (DeFond and
Francis 2005; Francis 2011). We use a setting where public firms are required to disclose the names
of the engagement partners to investigate the economic consequences of hiring a high quality
partner. We find that disclosure of the names of engagement partners provides informational value
to the capital market participants. In particular, investors perceive the financial reporting to be more
credible when audited by higher quality engagement partners. The market also reacts positively
when a firm switches from a low quality partner to a high quality partner. Moreover, hiring a high
quality partner serves as a positive signal, which helps IPO firms reduce the level of underpricing.
We also find that firms hiring higher quality engagement partners can lower their cost of debt, have
greater credit access, and are less likely to be required to post collateral.
Our paper contributes to the literature by providing evidence that investors value quality
individual auditors. To our knowledge, this study is the first to provide such evidence. Our paper is
also of interest to policymakers in that recent regulatory changes have begun to require the
identification of the names of engagement partners. In particular, the PCAOB (2013) has proposed
to require the public accounting firms to disclose the name of the engagement partner in the audit
report. One potential benefit of disclosing the identity of the engagement partner is that ‘‘it would
increase transparency about who is responsible for performing the audit, which could provide useful

November 2015
information to investors’’ (PCAOB 2009, 5). Our paper provides evidence supporting this
argument.
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APPENDIX A
Variable Definitions
ABSDA Absolute value of discretionary accruals, where discretionary accruals are
measured cross-sectionally based on the modified Jones (1991) model;
AGE Age of the firm since the firm was founded;
AMOUNT Loan borrowing amount (in thousands of NT dollars);
BETA Market model regression coefficient estimated using the past 1 year daily returns;
BIG N Indicator variable equal to 1 if the engagement partner works for one of the five
largest accounting firms (Arthur Andersen, Ernst & Young, Deloitte &
Touche, KPMG, and PricewaterhouseCoopers). The Big 5 becomes the Big 4
in 2003 when the Arthur Andersen Taiwanese operations merged with
Deloitte;
BTM Shareholder’s equity divided by market capitalization;
BMS Indicator variable equal to 1 if the firm’s maximum monthly market-adjusted
abnormal return during the year is greater than 20 percent, and 0 otherwise;
CapitalRaising Indicator variable equal to 1 if the firm announces to raise capital, and 0
otherwise;
CAR Market-adjusted daily cumulative abnormal returns;
ChgExec Indicator variable equal to 1 if the firm announces a change in executives, and 0
otherwise;
ChgQAuditFirmFE The change in QAuditFirmFE for firms hiring a new audit firm, and 0 for firms
retaining the same audit firm;
ChgQPartnerFE The change in QPartnerFE for the lead partner or total change in QPartnerFE
for both the lead and review partners;
CFO Cash flow from operations divided by total assets;
CI_AF Client importance at the audit firm level, measured as the client’s total assets
divided by SIZE_AF;
CI_EP Client importance at the engagement partner level, measured as the client’s total
assets divided by SIZE_EP;
CURRENT Current assets divided by current liabilities;
EA Indicator variable equal to 1 if the partner change announcement coincides with
an earnings announcement, and 0 otherwise;
EBITDA Earnings before interest and taxes plus depreciation deflated by total assets;
ELEC Indicator variable equal to 1 if an IPO firm is in the electronics industry, and 0
otherwise;
DChgAuditFirm Indicator variable equal to 1 if the firm changes its audit firm, and 0 otherwise;
DivAnn Indicator variable equal to 1 if the firm announces a change in dividends, and 0
otherwise;
FLOAT The proportion of shares sold at the IPO over shares outstanding;
FM Indicator variable equal to 1 if the firm selects the auction flotation method in an
IPO, and 0 otherwise;
IND_MKTSHARE_AF Audit firm industry market share, defined as the sum of the audit firm’s total
client revenues in the industry divided by the total industry revenues;
IND_MKTSHARE_EP Engagement partner industry market share, defined as the sum of the partner’s
total client revenues in the industry divided by the total industry revenues;
IND_PORTFOLIO_AF Audit firm portfolio concentration in a particular industry, defined as the sum of
the audit firm’s total client revenues in a specific industry divided by the sum
of all the audit firm’s client revenues;
IND_PORTFOLIO_EP Engagement partner portfolio concentration in a particular industry, defined as
the sum of the partner’s total client revenues in a specific industry divided by
the sum of all her clients’ revenues;

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APPENDIX A (continued)
INTEREST RATE The interest rate charged on the loan;
IPOSIZE Natural logarithm of the IPO amount raised;
JUNK Indicator variable equal to 1 if the company is not investment grade, and 0
otherwise;
LENGTHREL Number of days since a given bank started lending to a given borrower;
LEVERAGE Total debt divided by the sum of total debt and shareholders’ equity. Total debt
is the sum of short-term debt and long-term debt;
LOSS Indicator variable equal to 1 if earnings before extraordinary items are smaller
than 0, and 0 otherwise;
MATURITY The maturity of the debt (in days);
MKTRET Concurrent market return at the time of an IPO;
MKTRET48 Market index return for the period of 48 trading days before an IPO;
NONLINEAR Earnings surprise times the absolute value of earnings surprise;
NO RATING Indicator variable equal to 1 if the company does not have a credit rating, and 0
otherwise;
OHLSON The Ohlson O-score constructed based on Ohlson (1980);
OTC Indicator variable equal to 1 if the firm is traded in the over-the-counter market,
and 0 otherwise;
Q4 Indicator variable equal to 1 if the fiscal quarter is the fourth quarter, and 0
otherwise;
QPartnerFE Quartile rank of the negative partner fixed effects estimated based on Equation
(2);
QAuditFirmFE Quartile rank of the negative audit firm fixed effects estimated based on Equation
(2);
QFirmFE Quartile rank of the negative client firm fixed effects estimated based on
Equation (2);
PERSIST First-order autocorrelation of income from continuing operations per share for the
past 16 quarters;
RESTMT Indicator variable equal to 1 if the current-year annual report is restated later on,
and 0 otherwise;
RestatementAnn Indicator variable equal to 1 if the firm announces a restatement, and 0
otherwise;
SECURED Indicator variable equal to 1 if the loan requires collateral, and 0 otherwise;
SIZE Natural logarithm of the total assets (in millions of NT dollars);
SIZE_AF Size of the audit firm, measured as the sum of the total client assets audited by
the audit firm (in trillions of NT dollars);
SIZE_EP Size of the engagement partner, measured as the sum of the total client assets
audited by the engagement partner (in trillions of NT dollars);
STDCFO Standard deviation of cash flow from operations deflated by the lagged total
assets over the current and prior four years;
STDMKTRET48 Standard deviation of the market index return for the period of 48 trading days
before an IPO;
STDRET Standard deviation of stock returns over a 90-day period ending three days prior
to the earnings announcement;
SUCCESS The probability of successful purchase in the random drawing in the case of
oversubscription;
SURPRISE The seasonally differenced quarterly earnings per share deflated by the end of
quarter stock price;
SYNDICATION Indicator variable equal to 1 when the loan is syndicated, and 0 otherwise;
TANGIBILITY Net property, plant, and equipment (PP&E) divided by total assets;
TENURE_AF The number of continuous years the audit firm has worked for the client;

November 2015
APPENDIX A (continued)
TENURE_EP The number of continuous years the engagement partner has worked for the
client;
TIBOR Taiwan interbank overnight rate;
TURNOVER Net sales revenues divided by total assets; and
UP The level of IPO underpricing, defined as either the first one-day, three-day, or
20-day buy and hold return of the stock.
APPENDIX B
The online appendix provides detailed information on the predictions of the control variables in
Equations (2)–(6). It also reports the full regression results of Equation (3).
Online_Appendix: http://dx.doi.org/10.2308/accr-51054.s01

November 2015
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THE ACCOUNTING REVIEW American Accounting Association

Vol. 90, No. 6 DOI: 10.2308/accr-51054

Capital Market Consequences of Audit

The Accounting Review

The Accounting Review

II. HYPOTHESIS DEVELOPMENT

Engagement Partner Quality and Capital Market Consequences

The Accounting Review

The Accounting Review

Accrual-Based Measure of Engagement Partner Quality

III. SAMPLE SELECTION

The Accounting Review

IV. ESTIMATION OF INDIVIDUAL AUDIT PARTNER QUALITY

The Accounting Review

Panel A: Industry Distribution

The Accounting Review

The Accounting Review

The Accounting Review

Panel B: OLS Estimation of Engagement Partner Quality

The Accounting Review

The Accounting Review

DR2 ¼ R2Full R2no EP

Validation of Partner Fixed Effect Estimates

V. EQUITY MARKET CONSEQUENCES

Earnings Response Coefficients (ERCs)

The Accounting Review

Market Reaction to Partner Changes

The Accounting Review

Panel A: Descriptive Statistics

Panel B: ERC Regression Results

The Accounting Review

The Accounting Review

Panel A: Descriptive Statistics

The Accounting Review

CapitalRaising 117 0.03 0.16 0 0 0

Panel B: Regression Results on the Market Reactions to Partner Changes

The Accounting Review

Initial Public Offerings Underpricing

The Accounting Review

Panel A: Descriptive Statistics

The Accounting Review

VI. DEBT MARKET CONSEQUENCES

The Accounting Review

The Accounting Review

Debt Contract Analysis

(continued on next page)

The Accounting Review

SYNDICATION þ/ 0.098 0.092 þ 0.177 0.275* þ 0.152 0.872***

Dependent Variable ¼ Dependent Variable ¼ Dependent Variable ¼

VII. ADDITIONAL ANALYSES AND ROBUSTNESS TESTS

Determination of the Lead Partner

Results on Signed Accruals

The Accounting Review

An Alternative Proxy for Partner Quality

The Accounting Review

The Accounting Review

The Accounting Review

The Accounting Review

The Accounting Review

The Accounting Review

The Accounting Review

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