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Journal of Accounting and Public Policy 26 (2007) 131159 www.elsevier.

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Audit rm tenure and nancial restatements: An analysis of industry specialization and fee eects
Jonathan D. Stanley
a b

a,1

, F. Todd DeZoort

b,*

The University of Alabama, Culverhouse School of Accountancy, 365 Alston Hall, Tuscaloosa, AL 35487-0220, United States The University of Alabama, Culverhouse School of Accountancy, 328 Alston Hall, Tuscaloosa, AL 35487-0220, United States

Abstract This study investigates the relation between audit rm tenure and clients nancial restatements. Specically, we extend the audit tenure literature by assessing restatement-based reporting failures using dimensions of auditor expertise and independence previously assumed to underlie short and long audit tenure problems. Short tenure expertise and independence eects are hypothesized using audit rm industry specialization and audit fees as proxies. Long tenure independence eects are hypothesized using nonaudit fees as a proxy. Using matched-sample logistic regression and 382 companies with and without nancial restatements during 20002004, the results support prior ndings by indicating a negative relation between the length of the auditorclient relationship and the likelihood of restatement. For short tenure engagements, we nd that auditor industry specialization and audit fees are negatively related to the likelihood of restatement. This result is consistent with concerns about reduced audit quality due to a lack of client-specic knowledge and low audit fees on new audit engagements.
Corresponding author. Tel.: +1 205 348 6694; fax: +1 205 348 8453. E-mail addresses: jstanley@cba.ua.edu (J.D. Stanley), tdezoort@cba.ua.edu (F. Todd DeZoort). 1 Tel.: +1 205 348 6131. 0278-4254/$ - see front matter 2007 Elsevier Inc. All rights reserved. doi:10.1016/j.jaccpubpol.2007.02.003
*

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Alternatively, the long tenure results indicate an insignicant relation between nonaudit fees and the likelihood of restatement. This nding contradicts independence concerns about nonaudit fees paid to entrenched auditors. 2007 Elsevier Inc. All rights reserved.
Keywords: Audit tenure; Financial restatements; Industry specialization; Audit fees; Nonaudit fees

1. Introduction The objective of this study is to investigate the relation between audit rm tenure and nancial restatements. We extend the audit tenure literature by examining short tenure and long tenure expertise and independence factors previously only assumed to underlie the tenure problem. For example, Johnson et al. (2002) found that short audit tenures were inversely related to clients abnormal accruals, suggesting that a lack of client-specic knowledge or pressure to retain and prot from new clients could undermine audit quality. Geiger and Raghunandan (2002) made similar suggestions when interpreting their ndings of an inverse relation between audit tenure and the likelihood of a bankrupt company previously receiving an unqualied audit report. While both studies draw attention to longstanding concern about short tenure eects, there is little direct empirical evidence to support or refute suggestions that the eects are a function of auditor expertise and/or independence. Beyond short tenure concerns, interest in long tenure problems continues despite a lack of empirical evidence indicating their existence. The GAO (2003) highlighted that pressure to retain longstanding clients and high comfort levels with client management support calls for mandatory audit rm change to maintain adequate auditor objectivity and professional skepticism.2 The Chairman and CEO of TIAA-CREF (Biggs, 2002) argued before the US Senate for mandatory audit rm rotation every ve to seven years to (1) reduce auditors nancial incentives to subordinate judgment to management, (2) reduce the problem of cross-selling consulting and other services, and (3) close the revolving door that allows auditors to move to audit-sensitive positions in audited companies. Despite counterarguments emphasizing the importance of continuity and expertise in maintaining audit quality, the Sarbanes-Oxley Act (2002) mandated further study of the audit rm rotation issues.3 This study revisits
2 The GAO (2003) recommended that a decision about mandatory audit rm rotation be deferred to allow time to evaluate the eectiveness of the Sarbanes-Oxley Acts provisions. However, it also recommended that audit committees consider rotating audit rms when there is lengthy tenure of the auditor of record (p. 51). 3 The Sarbanes-Oxley Act (2002) highlights the dierence between audit partner rotation and audit rm rotation. Specically, while the Act only requires further study of the audit rm rotation issue, it mandates lead and concurring partner rotation every ve years.

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the long tenure independence question using nonaudit fees as a proxy for audit rm independence. We consider nancial restatements to be a unique and substantive domain for studying the relationship between audit tenure and nancial reporting quality for two reasons. First, nancial restatements due to error or fraud are de facto reporting failures.4 When audited nancial statements are restated, the validity of the audit opinion and the underlying audit process are subject to question because the originally released information was not free from material misstatement. While the extant literature (e.g., Geiger and Raghunandan, 2002; Johnson et al., 2002; Chung and Kallapur, 2003; Myers et al., 2003) provides some evidence of tenure eects using alternative quality proxies (e.g., abnormal accruals, audit opinions), our use of restatements helps address Carcello and Nagys (2004b) call for tenure eects research using objective and direct measures of nancial reporting quality. Second, nancial restatements among public companies represent a costly problem in US capital markets. The GAO (2002) estimated that restatements involving accounting irregularities increased 145% and cost investors approximately $100 billion during the ve-year period ending June 30, 2002. The SEC (2002) listed nancial restatements as a major factor undermining investor condence in nancial reporting and market eciency. In addition, numerous empirical studies (e.g., Dechow et al., 1996; Turner et al., 2001; Wu, 2003; Palmrose et al., 2004) provide evidence of strong negative market reactions to restatement announcements. Consideration of factors underlying restatement-based reporting failures has brought the external audit function under severe scrutiny (AICPA, 2002; GAO, 2002). One specic external audit attribute that has long been associated with auditors ability to provide adequate assurance is the length of the auditorclient relationship (e.g., Mautz and Sharaf, 1961; AICPA, 1978; POB, 2000; Imho, 2003). Using matched samples of restatement and non-restatement companies, the results indicate a signicant inverse relation between audit tenure and the likelihood of nancial restatement. For companies with short audit tenures, the multivariate results indicate that industry specialization and audit fees are inversely related to the likelihood of restatement. Finally, we nd no evidence that nonaudit fees for long audit tenure companies are positively related to the likelihood of restatement. Collectively, these results contribute to the tenure eects literature by providing evidence that audit tenure problems documented in other reporting domains (e.g., accrual accounting, going concern opinions)
Not all restatements are a result of errors or fraud in previously reported nancial statements. For example, certain changes in accounting principle require restatement of prior period nancial statements. These mandated restatements are beyond the scope of this study because they are not reporting failures.
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are robust to nancial reporting failures reported in formal restatements. These results also extend the literature by empirically addressing expertise and independence factors previously only speculated as relevant to tenure-related nancial reporting problems. The remainder of this paper is organized into four parts. Section 2 provides the hypothesis development. Section 3 describes the studys design and method. Section 4 presents the results. The nal section concludes with discussion of the studys implications and limitations.

2. Literature and hypothesis development 2.1. Audit tenure eects Previous audit tenure studies (e.g., Geiger and Raghunandan, 2002; Johnson et al., 2002; Myers et al., 2003; Mansi et al., 2004; Carcello and Nagy, 2004b; Ghosh and Moon, 2005) have predicted early tenure audit and nancial reporting problems due to a lack of client-specic knowledge and/or a lack of independence due to the auditors incentive to maintain new client relationships. Studies in this area have used a single audit tenure variable (length of auditorclient relationship) to evaluate links between audit tenure and various proxies for audit/nancial reporting quality. For example, several studies provide evidence of a link between the length of the auditorclient relationship and accrual quality. Johnson et al. (2002) found that audit tenure of less than three years was associated with higher absolute levels of unexpected accruals and lower accrual persistence in earnings. Similarly, Chung and Kallapur (2003) found that the length of the auditorclient relationship was inversely related to abnormal accruals. Myers et al. (2003) found a positive relation between the length of auditorclient relationship and earnings quality (proxied by discretionary and current accruals). The tenure eects literature also extends to audit reporting and regulation. Geiger and Raghunandan (2002) used knowledge and independence arguments when questioning whether the length of auditorclient relationship was related to the issuance of going concern opinions for bankrupt companies. Their results indicated that the likelihood of a company receiving a going concern opinion prior to bankruptcy was lower when auditors were in the initial years of the engagement. Carcello and Nagy (2004b) evaluated audit tenure aects among companies with fraudulent nancial reporting identied in SEC Accounting and Auditing Enforcement Releases (AAERs). They nd that the likelihood of fraudulent nancial reporting is greater in the initial three years of audit tenure. Alternatively, they do

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not nd that long audit tenure is associated with increased likelihood of fraud. Other recent studies extend the literature by considering market-based audit tenure eects. Overall, results in this area suggest that market participants discount the auditors monitoring ability during initial audit engagement years, consistent with a perception that audit/nancial reporting quality increases with tenure. For example, Mansi et al. (2004) document an inverse relation between rms cost of public debt and auditor tenure. Similarly, Ghosh and Moon (2005) show that the impact of reported earnings on (1) stock returns, (2) stock rankings, and (3) analysts one-year-ahead earnings forecasts is directly related to the length of the auditorclient relationship. We extend the literature involving the length of the auditorclient relationship to examine whether previous ndings are robust in the context of nancial restatements. Specically, prior to specic assessment of potential factors underlying audit tenure eects, we predict an overall inverse relation between audit tenure and client nancial restatement. Stated formally: H1: The likelihood of nancial restatement is inversely related to the length of the auditorclient relationship. 2.2. Audit rm expertise While prior studies discuss audit expertise and independence as potential underlying causes of audit tenure eects, empirical evidence is lacking. We test the eects of audit rm industry specialization as a dimension of expertise that can facilitate audit eectiveness in new engagements. Both Ashton (1991) and Bonner and Lewis (1990) found that industry expertise was positively correlated with an auditors ability to identify problems within nancial statements. Auditors gain industry expertise by working with clients from within an industry and by becoming familiar with the industrys unique accounting practices and risks. Industry expertise is related to auditor tenure because industry expertise can help compensate for a lack of client-specic knowledge. More specically, to the extent that a new audit client operates in an industry where the audit rm has extensive experience and knowledge, the engagement learning curve should be less pronounced. Theories explaining the eect of industry expertise on auditor judgment and decision-making (JDM) remain largely untested at the audit rm level (Gramling and Stone, 2001). However, several studies (e.g., Carcello and Nagy, 2004a; Krishnan, 2003) posit that increases in industry expertise at the audit rm level should be related to increases in industry expertise at the individual auditor level. Industry specialist rms are likely to have developed

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industry-specic training materials, databases, checklists, and other audit support aids (Carcello and Nagy, 2004a; Krishnan, 2003). The empirical literature is starting to provide evidence of a positive link between industry specialization at the audit rm level and nancial reporting quality. For example, Dunn and Mayhew (2004) found a positive association between audit rm industry specialization and client disclosure quality proxied by analysts evaluations in AIMR reports. Carcello and Nagy (2004a) found a negative association between audit rm industry specialization and client nancial fraud disclosed in SEC AAERs. Furthermore, the extant literature provides evidence that clients of industry specialist audit rms have larger earnings response coecients (e.g., Balsam et al., 2003) and lower levels of discretionary accruals (e.g., Balsam et al., 2003; Krishnan, 2003). These studies results support the prediction of a signicant relation between industry specialization and the likelihood of nancial restatement. Specically, audit rms that enter new audit engagements with relatively high industry specialization should be able to provide higher audit quality that lessens the chance of nancial restatements. Stated formally (in alternative form): H2: For companies with short audit tenures, the likelihood of nancial restatement is inversely related to the audit rms industry specialization. 2.3. Audit rm independence Accounting policymakers (e.g., GAO, 2003; SEC, 2000, 2003) have argued that auditor independence is aected by audit tenure. Consistent with this concern, a number of studies (e.g., Simon and Francis, 1988; Ettredge and Greenberg, 1990; Deis and Giroux, 1996; Sankaraguruswamy and Whisenant, 2005) have found that auditors frequently engage in low balling tactics where they oer audit services at prices substantially below market value or cost to attract new clients. Theoretically, future quasi-rents earned by incumbent auditors justify and oset losses on the early engagements (DeAngelo, 1981). Despite a lack of supportive evidence (Watkins et al., 2004), regulators have been critical of this practice because of the perceived independence problems it creates. For example, the Commission on Auditors Responsibilities (1978) issued a report (the Cohen Report) arguing that performing audit services below cost with the intention of recouping upfront losses at a later date is similar to performing audit services for a client that has unpaid audit fees outstanding (AICPA, 1978). This regulatory concern is supported by ndings from studies examining the psychology of sunk costs. Simon and Francis (1988) suggest that sunk costs resulting from lowball audit fees create an escalated commitment to

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continue the engagement in an attempt to recover the initial loss in later years.5 This commitment hinders auditor independence above and beyond the economic bond resulting from future quasi-rents. The empirical literature provides evidence of tenure eects in the initial years of auditorclient relationships. For example, adverse tenure eects documented by Geiger and Raghunandan (2002), and Johnson et al. (2002) lessened when auditorclient relationships exceeded ve years and three years, respectively. These ndings would be expected if such adverse short tenure eects were a function of lowball audit fees that reverted to normal levels after the initial audit years (Simon and Francis, 1988). Accordingly, we hypothesize an association between audit fees and the likelihood of nancial restatement by a company with a short audit rm tenure. Specically, relatively low audit fees should be positively related to the likelihood of restatement in the initial years of the auditorclient relationship. Stated formally: H3: For companies with short audit tenures, the likelihood of nancial restatement is inversely related to audit fees. While only short tenure eects have emerged in the empirical literature, concerns about long tenure independence problems persist. For example, regulators and interest groups argue that disproportionately large nonaudit fees that accumulate with audit tenure can diminish audit quality because they create incentive for auditors to acquiesce to client pressure (e.g., Conference Board, 2003; POB, 2000). The Sarbanes-Oxley Act (2002) addressed these entrenchment concerns by limiting the consulting services audit rms can provide their clients and by requiring study of the mandatory audit rm rotation issue.6 In its commissioned study, the GAO (2003) supported an earlier Conference Board (2003) call for audit committees to carefully consider auditor rotation when the auditor has long tenure and/or when the audit rm provides signicant nonaudit services to the company. While noting the potentially high nancial and institutional knowledge costs of mandatory rotation, the GAO acknowledged that both auditors under tenure limits and new auditors can bring a needed fresh look to nancial reporting issues that long tenure auditors may lack. The extant literature provides mixed evidence about the association between audit and nonaudit fees and nancial reporting quality. However, no study has empirically examined the long audit tenure/nonaudit service
5

Simon and Francis (1988) explain that audit fee data can only be used for an indirect test for lowballing. Proprietary audit cost and prot margin data are required for direct testing. 6 Mandatory audit rm rotation in the US has been discussed periodically over the past several decades. For example, the Metcalf Committee Report suggested in 1976 that the independence of auditors would be enhanced if audit rms were required to rotate clients after a set number of years (US Senate, 1976).

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link of concern to policymakers and regulators. Frankel et al. (2002) found a positive (negative) relationship between nonaudit (audit) fees and the likelihood of reporting small earnings surprises and various abnormal accruals measures. As a result, they suggested the need to investigate the relationship between audit (nonaudit) fees and nancial restatements. Alternatively, a number of studies (e.g., Ashbaugh et al., 2003; Chung and Kallapur, 2003; Raghunandan et al., 2003; Reynolds et al., 2004) fail to nd signicant links between fees and reporting quality. This study extends the literature by specically examining nonaudit fees and lengthy auditorclient relationships. Given persistent concerns that nonaudit fee entrenchment is associated with decreased nancial reporting quality for long audit tenures, we expect the likelihood of nancial restatement to be a function of the nonaudit fees earned by audit rms with long tenures. Stated formally, H4: For companies with long audit tenures, the likelihood of nancial restatement is positively related to nonaudit fees. 3. Design and sample 3.1. Model specication We use a series of logistic regression models to test the hypotheses. To test the rst hypothesis, the following model was estimated to assess whether the tenure eect ndings in prior audit tenure studies (e.g., Geiger and Raghunandan, 2002; Johnson et al., 2002; Myers et al., 2003; Carcello and Nagy, 2004b) are robust in the context of restatements: RSTMT b1 TENURE b2 INDSPEC b3 ADTFEE b4 NONADTFEE b5 ZFC b6 AGE b7 MERGER e 1 where RSTMT equals 1 if nancial statements were restated, else 0; TENURE equals the length of the auditorclient relationship (in years); INDSPEC equals the audit rms industry marketshare based on total sales audited within 2-digit SIC code; ADTFEE equals the natural log of total audit fees; NONADTFEE equals the natural log of total nonaudit fees; ZFC equals Zmijewskis (1984) nancial condition index; AGE equals the length of time as a publicly-traded company (in years); and MERGER equals 1 if the company was involved in merger activity, else 0. Similar to several prior matched-sample studies in accounting (e.g., Archambeault and DeZoort, 2001; Carcello and Nagy, 2004b; Menon and Williams, 2004), we estimate no-intercept models that address the independence assumption violation inherent in matched-sample designs. Hosmer and Lemeshow (2000) highlight that matched pair designs violate general logistic regression

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assumptions because they involve creation of matched observations that are not independent. Therefore, we calculated paired dierences (case minus control) for all variables and estimated no-intercept models using a constant (reecting the dierence between each matched case and control company) as the dependent variable.7 Although restatements often involve multiple years, we measured all variables in the rst year restated. This approach is consistent with prior research (e.g., Richardson et al., 2003) and with the studys objective to investigate nancial reporting quality at the time the problems rst arose, not when the problems were subsequently disclosed. TENURE was calculated using COMPUSTAT and annual proxy statements.8 We reviewed proxy statements to minimize measurement error associated with COMPUSTAT tenure measures. For example, COMPUSTAT may understate tenure because it records auditor data for companies only after they become public. Conversely, COMPUSTAT may overstate tenure because it can record up to three years of nancial data (as usually presented in the S-1 registration statement and initial 10-K ling) for new IPO companies added to the database. Thus, rst year auditors reporting on multiyear comparative statements for an IPO company may appear to have a three-year audit tenure.9 Auditor changes attributable to audit rm mergers were coded as a continuation of the prior auditor. Several control variables are included in the model to enhance its ability to detect tenure dierences between the restatement and control samples, reduce the possibility that the tenure results are a function of correlated omitted variables, and enhance comparability with prior studies and our subsequent short tenure and long tenure models. First, we used an industry marketshare proxy for INDSPEC to control for dierences in industry specialization among audit rms. Similar to prior studies (e.g., Carcello and Nagy, 2004a; Krishnan, 2003; Dunn and Mayhew, 2004), industry marketshare was calculated for each audit rm as the revenue of audit clients within a specic industry (denoted by 2-digit

7 Traditional logit models (with intercept) produced qualitatively similar results to those reported in the paper. 8 We used proxy statements to calculate TENURE if sucient information was publicly disclosed. Otherwise, TENURE was calculated using COMPUSTAT. TENURE was truncated as of 1974 to minimize the inuence of extreme observations and because COMPUSTAT does not contain auditor/opinion data for years prior to 1974. AGE also was truncated as of 1974 to be consistent with the TENURE calculation. 9 Mansi et al. (2004) note similar issues regarding tenure calculations based on COMPUSTAT data.

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SIC code) divided by the total revenue of all audited companies within that industry.10 Second, ADTFEE and NONADTFEE were used because of concern about the impact of audit and nonaudit fees on auditor independence and audit quality (e.g., SEC, 2000). Fee data were collected from annual proxy statements corresponding to the rst year restated.11 Third, we included a nancial condition measure (ZFC) to control for dierences in distress levels between the restatement and control samples because managements incentive to manipulate nancial statements is likely associated with the health of the company (Summers and Sweeney, 1998). Similar to prior studies (e.g., Carcello and Neal, 2000, 2003), we computed the ZFC index using coecients from Zmijewskis (1984) weighted probit model, where higher index values represent greater nancial distress levels. AGE was used because company age is likely correlated with the length of the auditorclient relationship (i.e., a one-year increase in tenure is, by default, a one-year increase in age). Finally, we controlled for the presence of merger activity because Kinney et al. (2004) found that acquisition activity was positively related to the likelihood of restatement. Following Kinney et al. (2004), MERGER was coded as a one if COMPUSTAT footnote data indicated the presence of merger activity, and zero otherwise.12 To test H2 and H3 (H4), we estimated the following logit model using a matched sample of restatement companies and control companies with short (long) audit tenures and publicly available fee data to test for dierences in audit rm industry marketshare and audit fees (nonaudit fees): RSTMTST=LT b1 INDSPEC b2 ADTFEE b3 NONADTFEE b4 ZFC b5 AGE b6 MERGER e 2

10 The portfolio share ratio is an alternative to the industry marketshare ratio. The portfolio share approach focuses on an audit rms concentration in a specic industry and has a denominator equal to the sum of all clients revenue. We did not use this alternative measure because it is highly correlated with industry size and it tends to ignore smaller industries (Neal and Riley, 2004). In addition, studies using the portfolio approach tend to lack variation in industry expertise when companies are matched on size and industry because industry size is highly correlated with this measure. 11 In 2000, the SEC required all registrants to disclose the most recent years audit and nonaudit fees in annual proxy statements led on or after February 5, 2001. Therefore, fee data is only available for companies that restated 2000 nancial statements or later. 12 We also considered a variety of alternative growth, complexity, risk, and governance control proxies that appear in other related studies. Specically, we controlled for book-to-market, earnings-to-price, total asset change (%), presence of foreign operations, number of business segments, operating cash ow eects, number of audit committee meetings, and board size. None of these control variables aected the signicance of our hypothesized variables.

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where RSTMT(ST), for short (63 years) tenure rms equals 1 if nancial statements were restated, else 0; and RSTMT(LT), for long (P5 years) tenure rms equals 1 if nancial statements were restated, else 0. The remaining variables are as previously dened. While the literature fails to provide clear consensus on specic short tenure and long tenure cutos, we initially dene short tenure in Model 2 as less than or equal to three years to be consistent with prior studies (e.g., Stice, 1991; Heninger, 2001; Geiger and Raghunandan, 2002; Johnson et al., 2002). In addition, we initially set the long tenure threshold in Model 2 at ve years to be consistent with Myers et al. (2003) and Geiger and Raghunandan (2002).13 Subsequent sensitivity analysis will evaluate the robustness of our results to alternative short and long tenure denitions. 3.2. Sample development Table 1 provides an overview of the restatement companies. The restatement sample was identied using a Boolean search (using the term restatement near(5) nancial) of annual SEC lings within 10-K Wizard for the ve-year period 1/1/200012/31/2004. As indicated in Table 1, Panel A, the search identied 1599 unique company observations. For companies with restatements covering multiple years, we focused data collection and analysis on the rst year of reported misstatement. We removed 756 companies with technical restatements to focus the sample on companies with annual restatements involving intentional or unintentional misapplications of GAAP. We also deleted 288 companies that did not use a Big 5/4 audit rm in the rst year of restatement. The focus on Big 4/5 auditors helps control for possible audit quality dierences between Big 5/4 and non-Big 5/4 audit rms (e.g., Becker et al., 1998) and manage the lack of tenure and industry specialization data available for many non-Big 5/4 rms. Three hundred fty-one (351) companies were removed because of missing data (e.g., audit fees, nonaudit fees, and ZFC components). Finally, we removed 13 companies that had no reasonable nonrestatement control company match (matching criteria described below). The sample screening process resulted in a nal sample of 191 restatement companies. Table 1, Panel B, describes the distribution of restatement companies by rst scal year restated. The concentration of sample companies restating annual nancial statements originally led during 2000 or 2001 is due to the large
13 Myers et al. (2003, p. 785) described three stages of the auditorclient relationship, using 5+ years as the long tenure stage, 34 years as a middle tenure stage, and 12 years as the short tenure stage. Their justication for this partitioning included reference to Congressional focus on ve years as a potential target for mandatory rm rotation. Geiger and Raghunandan (2002) found that early tenure audit reporting failures appear to taper o after ve years.

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Table 1 Sample description Panel A: Restatement sample development Initial number of unique company restatements Less: Interim and technical restatements Restatements involving non-Big 5/4 auditors Companies lacking proxy or nancial statement data Companies without a suitable match Final sample First scal year restated Full sample Short tenure sample (63 years) 17 (34%) 17 (34%) 13 (26%) 3 (6%) 0 (0%) 50 Short tenure sample (63 years) 14 (28%) 16 (32%) 1 (2%) 0 (0%) 1 (2%) 4 (8%) 5 (10%) 8 (16%) 0 (0%) 1 (2%) 50 Mean Med. Std. 1,599 (756) (288) (351) (13) 191 Long tenure sample (P5 years) 41 (39%) 42 (40%) 15 (14%) 5 (5%) 1 (1%) 104 Long tenure sample (P5 years) 19 (18%) 18 (17%) 2 (2%) 0 (0%) 9 (9%) 13 (13%) 13 (13%) 14 (13%) 7 (7%) 9 (9%) 104 Min. Max.

Panel B: Distribution by rst scal year restated 2000 74 (39%) 2001 69 (36%) 2002 36 (19%) 2003 11 (6%) 2004 1 (1%) Total 191 Industry Full sample

Panel C: Distribution by industry Computers 39 (20%) Durable manufacturers 43 (23%) Extractive 5 (3%) Financial 0 (0%) Pharmaceuticals 11 (6%) Retail 22 (12%) Services 25 (13%) Transportation 23 (12%) Utilities 8 (4%) Other 15 (8%) Total 191

Panel D: Summary nancial statistics for restatement companies Total assets ($ MM) Full sample 1619.65 252.87 6422.94 Short tenure sample (63 years) 676.70 251.11 1355.15 Long tenure sample (P5 years) 1696.13 296.37 4814.28 Total sales ($ MM) Full sample Short tenure sample (63 years) Long tenure sample (P5 years) Net income ($ MM) Full sample Short tenure sample (63 years) Long tenure sample (P5 years) 919.02 480.24 1065.78 90.69 138.42 92.75 177.71 144.24 256.00 3.45 16.32 0.13 2776.70 844.86 3254.19 512.85 380.43 621.74

4.97 4.97 5.87 0.04 1.72 0.04 5487.92 2351.75 5487.92

73501.00 6260.59 42227.00 30293.00 4820.83 30293.00 1232.00 34.39 612.00

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Table 1 (continued) Mean Operating cash ow ($ MM) Full sample Short tenure sample (63 years) Long tenure sample (P5 years) Tenure (years) Panel E: Tenure distribution 1 2 3 4 5 6 7 8 9 10+ Total 72.87 0.54 72.63 Med. 7.50 2.24 10.31 Std. 357.31 76.42 264.00 Min. 712.54 301.73 712.54 Max. 3681.00 169.68 1991.59

Full restatement sample 38 (20%) 13 (7%) 14 (7%) 15 (8%) 9 (5%) 16 (8%) 14 (7%) 8 (4%) 16 (8%) 48 (25%) 191

Full control sample 23 (12%) 10 (5%) 14 (7%) 13 (7%) 14 (7%) 11 (6%) 13 (7%) 8 (4%) 3 (2%) 82 (43%) 191

This table presents descriptive information for the full sample of restatement companies, and for the short and long tenure subsamples. Short tenure (Long tenure) is dened as an auditorclient relationship lasting less than or equal to three years (at least ve years). Panel A presents the sample development process. Panel B presents the distribution of restatement companies by the rst scal year restated. Panel C presents the distribution of restatement companies by industry. Following Raghunandan et al. (2003), industries are dened using SICs as follows: computers (73707379, 3570 3579, 36703679), durable manufactures (30003999, excluding 35703579 and 36703679), extractive (29002999, 13001399), nancial (60006799), pharmaceuticals (28302836), retail (50005999), services (70008999, excluding 73707379), transportation (40004899), utilities (49004999). Panel D presents summary nancial information for the restatement (sub)samples. Panel E presents frequency distributions for auditor tenure for the full sample of restatement and control companies.

percentage of lings restating multiple years and our focus on the rst year restated. Table 1, Panel C, presents the industry distribution results. Similar to Raghunandan et al. (2003), the restatements are concentrated in the Computers and Durable Manufacturers industries.14 Panel D of Table 1 presents summary nancial statistics for the sample. The mean (median) total assets for the full sample is $1,619.65 ($252.87) million.15
14 Financial institutions are not represented in the nal sample because they generally lack classied balance sheet information needed for the computation of the ZFC control variable (e.g., current assets and current liabilities). 15 The extant restatement literature in accounting reveals considerable variance in both the number of restatements identied and the size of restatement rms across sample time period and selection criteria. For example, while our sample rms are similar in size to the sample rms in Kinney et al. (2004), Palmrose and Scholz (2004), Palmrose et al. (2004), and Desai et al. (2006), they are smaller than those examined by Raghunandan et al. (2003). Accordingly, we suggest the need for caution when generalizing results across restatement studies.

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To test H1, we created a matched sample by matching each restatement company with a non-restatement control company based on year (the rst year restated in the Form 10-K or Form 10-K/A), industry classication (SIC), company size (total assets), and audit rm size (Big 4/5) to control for systematic temporal and cross-sectional dierences.16 The control companys Form 10-K corresponding to the year on which the restatement and control company were matched, and all subsequent annual lings, were then reviewed to ensure that the match years Form 10-K had not been restated. Table 1, Panel E, reports tenure frequency distributions for the full sample of restatement and control companies used to test H1. Although restatements occur across a range of audit tenures, the results indicate a relatively large number of restatements in the rst year of audit tenure. The frequency results also show a relatively large number of control companies with extended (10+ years) audit tenures. To test the short tenure hypotheses (H2 and H3), we matched 50 restatement companies with audit tenures of three years or less with non-restatement companies with audit tenure of three years or less. For the long tenure hypothesis (H4), 104 restatement companies with audit tenures of at least ve years were matched with non-restatement companies with audit tenures of ve years or more. The matching criteria related to scal year, industry, company size, and auditor size also were imposed on these subsamples.17 4. Results 4.1. Overall tenure results The results in Table 2, Panel A, present descriptive statistics for the 382 companies (191 restatement and 191 control) used to test H1. A t-test indicates
The matching protocol involved selecting a non-restatement company from the same four-digit SIC and within 15% in total assets. If no control company met these criteria, we then used threedigit or two-digit SIC match, respectively, and a maximum size deviation of 30%. The restatement company was dropped from the sample if no control company was within 30% of total assets and from the same two-digit SIC. Of the 191 restatement companies, 104, 25, and 62 were matched at the four-digit, three-digit, and two-digit SIC level, respectively. 173 (18) were matched on total assets within 15% (30%). 17 Audit rm tenure and company size (total assets) were not signicantly dierent between restatement and non-restatement companies for any of the short and long tenure subsamples (p > 0.10 in all cases). Of the 50 short tenure restatement companies, 14, 11, and 25 were matched at the four-digit, three-digit, and two-digit SIC level, respectively. 30 (20) were matched on total assets within 15% (30%). Of the 104 long tenure restatement companies, 48, 14, and 42 were matched at the four-digit, three-digit, and two-digit SIC level, respectively. 90 (14) were matched on total assets within 15% (30%).
16

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Table 2 Overall tenure results Restatement sample (n = 191) Mean Panel A: Univariate results TENURE 7.684 INDSPEC 0.210 ADTFEE 12.605 NONADTFEE 12.015 ZFC 1.534 AGE 11.529 MERGER 0.262 Variable (1) Med. 6.000 0.193 12.489 12.360 2.238 8.000 0.000 (2) Std. 7.342 0.075 1.042 2.611 3.165 8.687 0.441 (3) Control sample (n = 191) Mean 10.343 0.208 12.436 12.030 2.466 12.005 0.157 (4) Med. 7.000 0.202 12.324 12.445 2.758 9.000 0.157 (5) Std. 8.528 0.069 0.923 2.553 1.963 9.281 0.365 Dierence Pred. () () (?) (?) (+) () (+) (6) 0.561*** 0.062 0.086 0.036 0.080 0.002 v2 t

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3.80*** 0.37 2.83*** 0.06 3.67*** 0.62 2.82*** (7) 0.089 0.077 0.072 0.034 0.081 0.019

Panel B: Correlations among independent variables (Pearson above diagonal, Spearman below) (1) TENURE 0.062 0.119* 0.018 0.137* (2) INDSPEC 0.061 0.091 0.020 0.001 (3) ADTFEE 0.147** 0.053 0.267*** 0.182** * *** (4) NONADTFEE 0.020 0.123 0.313 0.075 (5) ZFC 0.192*** 0.008 0.127* 0.028 *** (6) AGE 0.526 0.010 0.104 0.046 0.112 (7) MERGER 0.079 0.091 0.047 0.036 0.094 Variable Panel C: Logistic regression results TENURE INDSPEC ADTFEE NONADTFEE ZFC AGE MERGER Pred. H1 () () (?) (?) (+) () (+) Coecient 0.074 1.082 0.523 0.041 0.118 0.031 0.559

10.70*** 0.41 5.81** 0.60 4.65** 2.55 2.91**

This table presents univariate and multivariate results from the full sample analysis. *,**,*** represent signicance at the .10, .05, and .01 level (one-tailed for results in the predicted direction), respectively. The variables are dened as follows: RSTMT = 1 if nancial statements were restated, else 0; TENURE = length of the auditorclient relationship (in years); INDSPEC = audit rms industry marketshare based on total sales audited within 2-digit SIC code; ADTFEE = natural log of total audit fees; NONADTFEE = natural log of total nonaudit fees; ZFC = Zmijewskis (1984) nancial condition index; AGE = length of time as a publicly-traded company (in years); and MERGER = 1 if the company was involved in merger activity, else 0. Panel A presents the mean, median, and standard deviation for the test variable of interest, TENURE, and the control variables. The mean log audit fees equal $298,045 (restatement sample) and $251,702 (control sample) in mean raw audit fees. The mean log nonaudit fees equal $165,215 (restatement sample) and $167,711 (control sample) in mean raw nonaudit fees. The tests of dierences in means are based on paired-sample t-tests. Nonparametric Wilcoxon rank sum tests yield qualitatively similar results in all cases. Panel B presents Pearson (Spearman) correlations among the test and control variables above (below) the diagonal. Panel C presents estimation results from the following matched-sample logistic regression model (Model 1): RSTMT b1 TENURE b2 INDSPEC b3 ADTFEE b4 NONADTFEE b5 ZFC b6 AGE b7 MERGER e Model v2 = 37.290; p < 0.0001. Max-rescaled R2 = 23.65%. n = 191 matched pairs.

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that the restatement companies have a shorter mean audit tenure (7.684 years) than the non-restatement companies (10.343 years; p < 0.01).18 In addition, the control variable results reveal that restatement companies pay higher audit fees (p < .01), have greater nancial distress levels (p < 0.01), and engage in more merger activity (p < 0.01) than non-restatement companies. Alternatively, the matched companies are similar in age, auditor industry specialization, and nonaudit fees (p > 0.10 for all comparisons). Table 2, Panel B, presents correlation results among TENURE and the control variables used in the multivariate analysis. Not surprising, the largest correlation is between TENURE and AGE (Pearson q = 0.561, p < 0.01). Otherwise, the correlation coecients are generally small, suggesting that multicollinearity is not a problem. Furthermore, we estimated variance ination factors (VIFs) for Model 1 and found the largest to be 1.53, well below the 10.00 threshold of concern recommended by Neter et al. (1996). The logit results in Panel C of Table 2 indicate a signicant TENURE model (v2 = 37.290; p < 0.0001). As hypothesized, the results indicate a significant negative relation between TENURE and the likelihood of nancial restatement (p < 0.01).19 Consistent with the univariate analysis, the ADTFEE, ZFC, and MERGER coecients are signicant (p < 0.05) and in the expected direction, while the INDSPEC, NONADTFEE, and AGE coecients are insignicant. Collectively, these results provide support for H1 and suggest that prior tenure ndings (e.g., Geiger and Raghunandan, 2002; Johnson et al., 2002; Myers et al., 2003; Carcello and Nagy, 2004b) generalize to nancial restatement contexts. Furthermore, our ndings of (1) larger audit fees, (2) similar nonaudit fees, and (3) increased merger activity for the restatement companies within our full sample is consistent with results documented in other recent restatement studies (e.g., Raghunandan et al., 2003; Kinney et al., 2004). However, the lack of signicance for INDSPEC is inconsistent with evidence suggesting that auditor industry specialization is positively related to nancial reporting quality (e.g., Balsam et al., 2003; Krishnan, 2003).

One-tail p-values are reported for tests involving directional predictions with results in the expected direction. 19 A number of tests were conducted to identify the eects of possibly inuential observations. For example, we winsorized the continuous variables at the top and bottom one percent of the sample distribution. All results were qualitatively similar using these modied samples in the univariate and multivariate analysis. We also examined logistic regression diagnostic statistics (e.g., leverage values and DFBetas) and found no observations exerting undue inuence on the hypothesis tests using the procedures outlined by Neter et al. (1996).

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4.2. Short tenure results Table 3 provides the results for H2 and H3, which predict that the likelihood of restatement by a short audit tenure company is inversely related to the audit rms industry specialization and audit fees, respectively. The univariate test results in Table 3, Panel A, show that the audit rms represented in the short tenure restatement sample have less industry specialization than the audit rms in the control sample (p < 0.05). Consistent with the full sample analysis discussed previously, the short tenure restatement rms exhibit greater nancial distress than their control sample counterparts (p < 0.01). No signicant univariate dierences emerge for ADTFEE, NONADTFEE, AGE, or MERGER. Table 3, Panel B, presents correlations among the test and control variables included in Model 2. The largest correlations are between INDSPEC and ADTFEE (Pearson q = 0.348, p < 0.05) and ZFC and ADFEE (Pearson q = 0.366, p < 0.01). Analysis of VIFs for Model 2 indicates that the largest equals 1.29. Overall, this evidence suggests that multicollinearity is not a problem. The logit results in Table 3, Panel C, indicate a signicant short tenure model (v2 = 15.666; p = 0.016). Consistent with H2 and the univariate results, the INDSPEC coecient is negative and statistically signicant (p < 0.05), suggesting the benets of industry specialization for overcoming a lack of client-specic knowledge in initial audit engagement years.20 In addition, after controlling for auditor industry specialization and nancial distress, the results indicate a signicantly negative ADTFEE coecient (p < 0.05). This nding provides support for the H3 prediction of an inverse relation between audit fees and likelihood of restatement, and is consistent with concerns that lowball audit pricing strategies jeopardize auditor independence and audit quality on new engagements. 4.3. Long tenure results The results in Table 4 do not support our H4 prediction of a positive relation between nonaudit fees and the likelihood of restatement for long audit tenure companies. The t-test results in Panel A of Table 4 indicate the restatement companies mean nonaudit fee ($207,109) is not statistically dierent than the non-restatement companies mean nonaudit fee ($216,642; p > 0.10). In contrast, the results reveal that the restatement companies pay
One of the industries represented in our short tenure sample has fewer than 30 companies. The results are qualitatively similar when the one matched-pair within this industry is dropped, suggesting small industries do not inuence the industry specialization results (Carcello and Nagy, 2004a).
20

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Table 3 Short tenure industry specialization and audit fee results Restatement sample (n = 50) Mean Panel A: Univariate results INDSPEC 0.189 ADTFEE 12.328 NONADTFEE 11.134 ZFC 0.481 AGE 8.740 MERGER 0.280 Variable (1) Med. 0.188 12.201 12.031 2.201 5.000 0.000 (2) Std. 0.061 0.849 3.260 4.332 7.979 0.454 Control sample (n = 50) Mean 0.213 12.391 11.397 2.235 9.180 0.280 (3) Med. 0.207 12.420 12.364 2.726 6.000 0.000 (4) Std. 0.068 0.805 3.648 2.167 8.392 0.454 Dierence Pred. () () (?) (+) () (+) (5) 0.041 0.025 0.072 0.054 .278* v2 3.75** 3.51** 0.39 5.70*** 0.17 0.09 t 1.88** 0.52 0.40 2.76*** 0.29 0.00 (6) 0.064 0.236* 0.028 0.112 0.258*

Panel B: Correlations among independent variables (Pearson above diagonal, Spearman below) (1) INDSPEC 0.348** 0.279** .122 (2) ADTFEE 0.309** 0.229 0.366*** (3) NONADTFEE 0.195 0.298** 0.121 (4) ZFC 0.203 0.307** 0.127 (5) AGE 0.068 0.037 0.107 0.088 * (6) MERGER 0.111 0.240 0.072 0.038 Variable Panel C: Logistic regression results INDSPEC ADTFEE NONADTFEE ZFC AGE MERGER Pred. H2 () H3 () (?) (+) () (+) Coecient 8.455 1.090 0.048 0.312 0.014 0.157

This table presents univariate and multivariate results from the short tenure (63 years) sample analysis. *,**,*** represent signicance at the .10, .05, and .01 level (one-tailed for results in the predicted direction), respectively. The variables are dened as follows: RSTMT = 1 if nancial statements were restated, else 0; INDSPEC = audit rms industry marketshare based on total sales audited within 2-digit SIC code; ADTFEE = natural log of total audit fees; NONADTFEE = natural log of total nonaudit fees; ZFC = Zmijewskis (1984) nancial condition index; AGE = length of time as a publicly-traded company (in years); and MERGER = 1 if the company was involved in merger activity, else 0. Panel A presents the mean, median, and standard deviation for the test variables of interest, INDSPEC and ADTFEE, and the control variables. The mean log audit fees equal $225,934 (restatement sample) and $240,626 (control sample) in mean raw audit fees. The mean log nonaudit fees equal $68,460 (restatement sample) and $89,054 (control sample) in mean raw nonaudit fees. The tests of dierences in means are based on paired-sample t-tests. Nonparametric Wilcoxon rank sum tests yield qualitatively similar results in all cases. Panel B presents Pearson (Spearman) correlations among the test and control variables above (below) the diagonal. Panel C presents estimation results from the following matched-sample logistic regression model (Model 2): RSTMT b1 INDSPEC b2 ADTFEE b3 NONADTFEE b4 ZFC b5 AGE b6 MERGER e Model v2 = 15.666; p = 0.016. Max-rescaled R2 = 35.86%. n = 50 matched pairs.

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higher mean audit fees ($329,062) than the non-restatement companies ($268,606; p < 0.01). The correlation results presented in Table 4, Panel B, show relatively small associations among the test and control variables included in Model 2, with the exception of ADTFEE and NONADTFEE (Spearman q = 0.408, p < 0.01). As with the other models, analysis of VIFs suggested that multicollinearity was not a problem.21 The logit results in Table 4, Panel C, indicate that the long tenure nonaudit fee model is signicant (v2 = 14.295; p = 0.027). Similar to the univariate results, the multivariate results do not show a signicant coecient for NONADTFEE (p > 0.10). The signicant positive coecients for ADTFEE (p < 0.01) and MERGER (p < 0.05) suggest higher audit fees and a greater likelihood of merger activity for long tenure restatement companies. While contrary to the short tenure prediction and ndings, the long tenure audit fee result is consistent with the results in Kinney et al. (2004). Specically, Kinney et al. (2004) found that restatement rms paid larger audit fees than nonrestatement rms and conjectured that the larger fees could reect auditors response to heightened ex ante misstatement risk (i.e., additional audit eort and/or fee premiums). When considered with the signicant short tenure industry specialization (H2) result, the insignicant long tenure INDSPEC eect helps highlight the importance of industry specialization in managing a lack of client-specic knowledge inherent in new audit engagements. 4.4. Sensitivity analysis We conducted a series of sensitivity tests to evaluate the robustness of our results. We rst examined the overall tenure results that support H1. To evaluate whether the TENURE results are capturing client characteristics linked to both auditor changes and nancial reporting quality (e.g., DeFond and Subramanyam, 1998), we re-estimated Model 1 after removing restatement and control companies with audit tenures of one year or less (i.e., rst-year audit engagements). The results (not tabulated) show that TENURE remains negative and signicant (coecient = 0.051, p < 0.05) after deleting the initial year audit engagement companies. We also dropped AGE from the model because of the correlation between TENURE and the number of years the company has been publicly traded. Again, we nd that TENURE remains negative and signicant (coecient = 0.054, p < 0.01).
21 Given concern about correlation between audit and nonaudit fees (e.g., Whisenant et al., 2003), we also alternatively dropped ADTFEE and NONADTFEE from the models to test whether fee correlations aect the multivariate results reported throughout the paper. The revised NONADTFEE (ADTFEE) results are qualitatively similar to those reported when ADTFEE (NONADTFEE) is excluded.

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Table 4 Long tenure nonaudit fee results Restatement sample (n = 104) Mean Panel A: Univariate results NONADTFEE 12.241 INDSPEC 0.217 ADTFEE 12.704 ZFC 2.015 AGE 12.913 MERGER 0.221 Variable (1) Med. 12.437 0.196 12.634 2.261 10.000 0.000 (2) Std. 2.398 0.081 1.022 2.519 8.473 0.417 Control sample (n = 104) Mean 12.286 0.214 12.501 2.110 14.038 0.144 (3) Med. 12.357 0.219 12.378 2.748 11.000 0.000 (4) Std. 1.645 0.070 0.904 3.469 8.859 0.353 (5) 0.117 0.164* 0.052 0.046 0.009 v2 1.39 0.24 8.83*** 0.02 0.92 3.87** Dierence Pred. (+) () (?) (+) () (+) t 0.21 0.31 2.79*** 0.22 1.17 1.52* (6) 0.185* 0.071 0.122 0.010 0.006

Panel B: Correlations among independent variables (Pearson above diagonal, Spearman below) (1) NONADTFEE 0.012 0.283*** 0.124 (2) INDSPEC 0.022 0.061 0.120 (3) ADTFEE 0.408*** 0.002 0.133 (4) ZFC 0.141 0.164* 0.131 (5) AGE 0.096 0.083 0.025 0.104 (6) MERGER 0.115 0.142 0.142 0.087 Variable Panel C: Logistic regression results NONADTFEE INDSPEC ADTFEE ZFC AGE MERGER Pred. H4 (+) () (?) (+) () (+) Coecient 0.139 1.080 0.960 0.007 0.022 0.850

This table presents univariate and multivariate results from the long tenure (P5 years) sample analysis. *,**,*** represent signicance at the .10, .05, and .01 level (one-tailed for results in the predicted direction), respectively. The variables are dened as follows: RSTMT = 1 if nancial statements were restated, else 0; NONADTFEE = natural log of total nonaudit fees; INDSPEC = audit rms industry marketshare based on total sales audited within 2-digit SIC code; ADTFEE = natural log of total audit fees; ZFC = Zmijewskis (1984) nancial condition index; AGE = length of time as a publicly-traded company (in years); and MERGER = 1 if the company was involved in merger activity, else 0. Panel A presents the mean, median, and standard deviation for the test variable of interest, NONADTFEE, and the control variables. The mean log audit fees equal $329,062 (restatement sample) and $268,606 (control sample) in mean raw audit fees. The mean log nonaudit fees equal $207,109 (restatement sample) and $216,642 (control sample) in mean raw nonaudit fees. The tests of dierences in means are based on paired-sample t-tests. Nonparametric Wilcoxon rank sum tests yield qualitatively similar results in all cases, except for ZFC, which is larger for the restatement sample (p < 0.10). Panel B presents Pearson (Spearman) correlations among the test and control variables above (below) the diagonal. Panel C presents estimation results from the following matched-sample logistic regression model (Model 2): RSTMT b1 NONADTFEE b2 INDSPEC b3 ADTFEE b4 ZFC b5 AGE b6 MERGER e Model v2 = 14.295; p = 0.027. Max-rescaled R2 = 17.12%. n = 104 matched pairs.

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We also assessed whether the reported short tenure and long tenure results are sensitive to alternative tenure cutos and alternative industry specialization and fee measures. For example, we investigated whether the three-year short tenure industry specialization and audit fee eects remained signicant using a two-year short tenure cuto. The literature (e.g., Loebecke et al., 1989; AICPA, 1992) provides some evidence that audit and nancial reporting problems are most likely to occur during the initial two years of the auditorclient relationship.22 The results in Table 5, Panel A, indicate that INDSPEC and ADTFEE remain negative and signicant at the .05 level using a matched sample of 31 restatement and non-restatement companies with audit tenures of no more than two years. Furthermore, the INDSPEC and ADTFEE coecients increased by approximately 70% and 50% in the re-estimated model, respectively, when compared to the coecients estimated using a sample with a three-year tenure cuto. These results suggest that the positive eects of industry specialization and audit fees on nancial reporting quality for short tenure engagements are not driven by audit rms with the longest tenure within the sample. In addition, we estimated the two-year and three-year models using alternative industry specialization proxies based on total assets audited within an industry (Carcello and Nagy, 2004a) and total number of clients within the industry (Balsam et al., 2003). The results (not tabulated) are qualitatively similar using these alternative proxies. Next, we evaluated whether the nonaudit fee (H4) results depend on the specic long tenure threshold used. Specically, although prior studies (e.g., Myers et al., 2003) have used ve-year long tenure thresholds, the literature also includes studies using thresholds of up to nine-years (e.g., Johnson et al., 2002; Carcello and Nagy, 2004b). Accordingly, we re-estimated the initial ve-year long tenure model (Model 2) using longer thresholds of seven and nine years. As the results in Table 5, Panel B, indicate, NONADTFEE remained insignicant in both cases, suggesting our reported results are not sensitive to long tenure threshold. To assess whether our long tenure fee results are sensitive to using nonaudit fees as a proxy for auditor independence, we conducted additional analysis using the ratio of nonaudit fees to audit fees. Despite concerns that fee ratios ignore fee magnitude (Reynolds et al., 2004) and are dicult to interpret (Kinney et al., 2004), the SEC (2000) listed the ratio of nonaudit fees to audit fees as an important indicator for assessing audit rm independence. Consistent with the nonaudit fee results, the results in Table 5, Panel C, indicate that
22 The AICPAs Quality Control Inquiry Committee found that allegations of audit failures occur almost three times as often during this initial two-year period (AICPA, 1992). Similarly, Loebecke et al. (1989) found that audit partners report that approximately one-third of accounting irregularities and management fraud encountered occur during the rst two years of the audit engagement.

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Table 5 Supplemental logistic regression results Variable Pred. Coecient 14.349 1.625 0.143 0.345 0.054 0.183 v2 4.23** 3.63** 1.42 3.49** 0.98 0.06

Panel A: Alternative short tenure denition (62 years) INDSPEC H2 () ADTFEE H3 () NONADTFEE (?) ZFC (+) AGE () MERGER (+) Model v2 = 14.715; p = 0.023 Max-rescaled R2 = 50.39% n = 31 matched pairs, Variable Pred. P7 years Coecient v
2

P9 years Coecient 0.183 1.448 0.784 0.042 0.009 0.786 5.729 (0.454) 14.71% 49 P7 years P9 years v
2

v2 1.06 0.20 3.46** 0.30 0.07 1.56

Panel B: Alternative long tenure denitions (P7 years and P9 years) NONADTFEE H4 (+) 0.153 1.34 INDSPEC () 2.899 1.14 ADTFEE (?) 0.880 6.73*** ZFC (+) 0.015 0.07 AGE () 0.012 0.24 MERGER (+) 0.962 3.32** Model v2 (p-value): Max-rescaled R2: n matched pairs: Variable Pred. 11.033 (0.087) 18.02% 76 P5 years Coecient v
2

Coecient

Coecient 0.051 0.943 0.002 0.015 0.592 1.680 (0.891) 4.49% 49 P9 years

v2 0.23 0.09 0.00 0.21 1.09

Panel C: Alternative long tenure independence proxy (fee ratio) FEERATIO H4 (+) 0.039 0.37 0.004 INDSPEC () 0.406 0.04 2.039 ZFC (+) 0.007 0.02 0.002 AGE () 0.023 1.20 0.012 MERGER (+) 0.600 2.26* 0.642 Model v2 (p-value): Max-rescaled R2: n matched pairs: Variable Pred. 4.100 (0.535) 5.15% 104 P5 years Coecient v
2

0.00 0.62 0.00 0.21 1.84

2.802 (0.731) 4.83% 76 P7 years Coecient v


2

Coecient 0.366 0.971 0.010 0.011 0.478

v2 1.53 0.10 0.02 0.11 0.69

Panel D: Alternative long tenure independence proxy (total fee) 0.488 TOTALFEE H4 (+) 0.501 4.70** INDSPEC () 0.640 0.09 2.469 ZFC (+) 0.007 0.02 0.019 AGE () 0.025 1.40 0.012 MERGER (+) 0.591 2.15* 0.591

3.50** 0.87 0.13 0.25 1.52

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Table 5 (continued) Variable Pred. Model v (p-value): Max-rescaled R2: n matched pairs:
2

P5 years Coecient v
2

P7 years Coecient 6.619 (0.251) 11.12% 76 v


2

P9 years Coecient 3.075 (0.689) 8.11% 49 v2

8.843 (0.116) 10.87% 104

This table presents supplemental multivariate results. *,**,*** represent signicance at the .10, .05, and .01 level (one-tailed for results in the predicted direction), respectively. The variables are dened as follows: RSTMT = 1 if nancial statements were restated, else 0; ADTFEE = natural log of total audit fees; NONADTFEE = natural log of total nonaudit fees; FEERATIO = ratio of total nonaudit fees to total audit fees; TOTALFEE = natural log of total fees; INDSPEC = audit rms industry marketshare based on total sales audited within 2-digit SIC code; ZFC = Zmijewskis (1984) nancial condition index; AGE = length of time as a publicly-traded company (in years); and MERGER = 1 if the company was involved in merger activity, else 0. Panel A presents the estimation results from Model 2 (presented in Table 3) using the audit fee independence proxy and an alternative short tenure sample, where short tenure is dened as less than or equal to two years. Panel B presents the estimation results from Model 2 (presented in Table 4) using the original nonaudit fee independence proxy and two alternative long tenure samples, where long tenure is dened as at least seven and nine years. Panel C presents the estimation results from the augmented Model 2 using the ratio of nonaudit to audit fees as the independence proxy and the three long tenure samples, where long tenure is dened as at least ve, seven, and nine years. Panel D presents the estimation from the augmented Model 2 using total fees as the independence proxy and the three long tenure samples.

the ratio of total nonaudit fees to audit fees is not signicantly related to the likelihood of restatement for our ve-, seven-, or nine-year samples. This nding further supports our conclusion that large nonaudit fees do not appear to be linked to adverse nancial reporting outcomes requiring subsequent correction and restatement. The magnitude of total fees also has been examined in previous studies assessing auditor independence (e.g., Frankel et al., 2002; Ashbaugh et al., 2003). Several papers (e.g., Beck et al., 1988; Magee and Tseng, 1990; Bazerman et al., 1997) suggest that a fee-based economic bond between auditor and client threatens auditor independence. This perspective posits that all client payments to the auditor (including audit and nonaudit fees) strengthen this bond and undermine auditor independence. Accordingly, we use total fees as an alternative fee-based independence proxy for long tenure rms to facilitate comparison with prior research. The results in Table 5, Panel D, indicate a signicant positive association between total fees and the likelihood of restatement (p < 0.05) for the ve-year and seven-year tenure samples. However, we highlight that this total fee eect appears to be driven by the magnitude of

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audit fees given the signicant ADTFEE and insignicant NONADTFEE results presented in Table 4, Panel C, and Table 5, Panel B. Audit fees arguably hinder auditor independence less than nonaudit fees (SEC, 2000). Furthermore, regulators do not appear to be concerned about the potential adverse eect of large audit fees on the auditors independence (Kinney et al., 2004). Accordingly, we question whether auditor independence is the construct underlying the total fee eect on the likelihood of restatement within our sample companies.23 5. Discussion and conclusion This study provides some initial empirical evidence on the link between nancial restatements, audit tenure, and tenure-related proxies for audit rm expertise and independence. Consistent with prior audit tenure eect studies (e.g., Geiger and Raghunandan, 2002; Johnson et al., 2002; Carcello and Nagy, 2004b; Ghosh and Moon, 2005), we nd evidence of an inverse relation between audit tenure and nancial restatement. Decomposition of the overall tenure eect reveals that the likelihood of restatement is inversely related to the audit rms industry marketshare and audit fees for companies with short audit tenures. The long tenure results indicate no signicant relation between nonaudit fees and likelihood of restatement. Collectively, these results have a number of research, policy, and practice implications. From a research perspective, the results extend the tenure eects literature in two primary ways. First, this study provides evidence that audit tenure problems documented in other nancial reporting domains (e.g., accrual accounting) are robust and generalize to relatively objective nancial restatement events. Second, this study provides an initial empirical examination of underlying expertise and independence factors that have only been suggested to date. The short tenure industry specialization results are consistent with concerns about reduced audit quality due to a lack of client-specic knowledge on new audit engagements. While this inference is supported further by the insignicant industry specialization eect in long tenure companies, future research is needed to better distinguish between specialization and learning curve eects in new audit engagements. The short tenure audit fee results provide initial support for prior concerns about adverse lowballing eects (e.g., Simon and Francis, 1988; Ettredge and Greenberg, 1990; Deis and Giroux, 1996). Specically, our multivariate results support regulator concern that lowballing impairs audit quality during the iniWe also evaluated the roles of the nonaudit fee ratio and total fees in determining the likelihood of restatement for the full sample. Neither variable is signicant when evaluated individually in lieu of ADTFEE and NONADTFEE in Model 1. Otherwise, the results were qualitatively similar to those reported in Table 2, Panel C.
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tial years of an audit engagement (e.g., AICPA, 1978; SEC, 2000). This short tenure result is particularly prominent given our ndings of higher audit fees for restatement rms in the full sample and long tenure sample. Given the relatively small short tenure sample, future research is needed to test whether this audit fee eect is generalizable to other settings. Other than the results presented in this study, very little empirical data exists on the eects of lowballing on audit quality (Watkins et al., 2004). We also suggest the need for future research to evaluate potential audit quality tradeos involving short tenure industry specialization gains and lowballing losses. From a policy perspective, the results do not support calls for mandatory audit rm rotation and regulatory concern that nonaudit services hinder audit rm independence and audit quality in the later years of the auditorclient relationship (e.g., Sarbanes-Oxley Act, 2002; SEC, 2003). In addition, the short tenure industry specialization ndings support concerns about the potential costs of mandatory audit rm rotation (e.g., PwC, 2002; GAO, 2003). More specically, our results highlight the risk of decreased audit quality in forced auditor changes where access to a new auditor with specialized knowledge is limited. These ndings also support concerns among large public accounting rms and Fortune 1000 companies that auditor changes increase the risk of audit failure in early audit years because auditors may fail to detect material misstatement while they are acquiring the necessary knowledge of the companys operations, systems, and nancial reporting practices (GAO, 2003, p. 6). The short tenure audit fee results provide indirect support for the longstanding regulatory concern over the adverse eects of lowballing. Finally, from a practice perspective, the ndings of this study and prior studies (e.g., Dunn and Mayhew, 2004; Carcello and Nagy, 2004a) emphasize the importance of audit rm industry specialization. Collectively, our results suggest that specialization has the potential to compensate for a lack of client-specic knowledge during the initial years of the audit engagement. While several accounting studies suggest concern about the learning curve associated with new audit clients (e.g., Beck et al., 1988; Stice, 1991; Geiger and Raghunandan, 2002; Johnson et al., 2002), future research should continue to evaluate the extent that industry specialization at the rm and oce level (e.g., Francis et al., 2005) can mitigate adverse learning curve eects. The results should be evaluated in the context of the studys limitations. First, the possibility of measurement error exists given our proxies and specic measures. For example, despite the SECs (2003) issuance of new fee disclosure rules designed to improve consistency and transparency, companies continue to have discretion when reporting and categorizing audit and nonaudit fees in annual proxy statements (Weil and Rapoport, 2003). Second, despite our matching process and use of various controls in the study, correlated omitted variables may aect the results. Specically, we recognize the possibility of endogeneity (e.g., DeFond et al., 2002; Whisenant et al., 2003) with respect to

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auditor tenure. To the extent our tenure variable reects underlying auditor change decisions, consideration of the studys implications should include the possibility that audit tenure may respond to an unspecied omitted variable or simultaneously to changes in the likelihood of restatement. Acknowledgements We gratefully acknowledge the helpful comments and suggestions received from Debbie Archambeault, Mark Beasley, Dana Hermanson, Gary Holstrum, Rich Houston, Rob Ingram, Karen Maguire, Mary Stone, Gary Taylor, and workshop participants at The University of Alabama and the 2004 American Accounting Association Annual Meeting. References
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