Audit Firm Tenure And Earnings Management: The Impact Of Changing Accounting Standards In UK Firms

Abstract

The objective of this paper is to investigate the association between audit firm tenure and earnings management (EM) and whether it is conditional on using the same set of accounting standards. The sample of this study comprises UK listed companies for five years by collecting data using WorldScope for financial and accounting standards data and FAME databases for audit tenure data. We use discretionary accruals measures as our measure of EM. We measure total accruals and current accruals using the cash flow statement approach. UK data allows us to examine the impact of changing accounting standards because one group of firms continually reported under UK GAAP whereas another group of firms changed its accounting standards from UK GAAP to IFRS. We find, in accordance with prior studies, a negative association between audit firm tenure and earnings management for our pooled UK sample. However, we find that this negative association only holds for those firms which had not changed their accounting standards. Furthermore, we document empirical results that the effect of audit firm tenure on EM is contingent upon the same set of accounting standards being used. The results agree with the recent trend of research that suggests that longer audit firm tenure does not compromise auditor independence but in fact improves the audit quality. Moreover, the results reported in the paper call for a careful cost benefit analysis by standards setters before implementing a dramatic change in accounting standards. Such changes could have a negative impact on audit quality. One possible explanation for both the accounting standards results is that auditors need a stable and strong learning environment if they are to mitigate earnings management. The results of this paper argue strongly against mandatory audit firm rotation through illustrating the positive impact that extended audit firm tenure has on improving audit quality.