From: Geiger, Marshall [mgeiger@richmond.edu]
Sent: Thursday, December 12, 2002 9:31 PM
To: 'rule-comments@sec.gov'
Subject: File No. S7-49-02

12/12/02

Dear SEC:

I am attaching a file containing a research paper we conducted regarding auditor employment by former clients. Our findings indicate a higher level of absolute discretionary accruals by firms hiring financial reporting people (CFO, VP-Finance, Controllers) from their current audit firm than firms hiring other individuals from other CPA or non-CPA firms.

In short, our empirical findings support limiting this employment activity – as indicated in Sarbanes-Oxley 2002 and this SEC Release. Unfortunately, we can not test whether the employment restriction would be effective, but we do demonstrate that presently the practice leads to excessive earnings management.

If you have any questions, please feel free to contact me at the number below.

Thank you for your consideration,

Marshall A. Geiger
Professor of Accounting
University of Richmond
1 Gateway Road
Richmond, VA 23173
804/287-1923
804/289-8878 fax

The Auditor to Client Revolving Door and Earnings Management

Marshall A. Geiger
Professor
Accounting Department
E. Claiborne Robins School of Business
University of Richmond
Richmond, VA 23173
Telephone: (804) 287-1923
Fax: (804) 289-8878
mgeiger@richmond.edu

David S. North
Assistant Professor
Finance Department
E. Claiborne Robins School of Business
University of Richmond
Richmond, VA 23173
Telephone: (804) 287-1938
Fax: (804) 289-8878
dnorth@richmond.edu

Brendan T. O'Connell
Associate Professor
School of Accounting and Finance
Deakin University
Geelong, Victoria 3217
AUSTRALIA
Telephone: ++ 61 3 5227 1287
Fax: ++ 61 3 5227 2264
boconne2@richmond.edu

Draft: December 3, 2002

Please do not quote without ermission.

The Auditor to Client Revolving Door and Earnings Management

ABSTRACT

The recent passing of the Sarbanes-Oxley Act of 2002 resulted in restrictions being placed on the so-called "revolving door" where a company hires a senior financial reporting executive from its current external audit firm. This action, despite a lack of empirical research into the practice, reflects continued concerns about auditor independence emanating from Enron, WorldCom, Adelphi and other prominent recent corporate collapses and fraudulent reporting. Our study empirically examines a sample of firms where influential financial reporting executives such as the CFO, VP-Finance, or Controller are hired by the public company directly from their external audit firm. Our findings provide evidence of earnings management by the companies engaging in the hiring of individuals from their audit firm, both compared to companies hiring individuals from non-audit firms, and companies hiring individuals from audit firms other than their current external auditor. The results are robust to additional tests undertaken to address the concerns of Dechow et al. (1995) and Young (1999) regarding discretionary accrual models. However, we find no evidence of increased earnings management by these individuals in more recent years. Overall, our results lend support to regulators recent actions to restrict these employment practices.

Classification codes: G32, G34, M4

Key words: earnings management, accruals, auditor independence, corporate governance.

The Auditor to Client Revolving Door and Earnings Management

I. INTROUCTION

A key issue to emerge from recent high-profile financial scandals such as Enron, Global Crossing, and Waste Management in the US and HIH Insurance in Australia is the so-called "revolving door" where a company hires senior financial reporting executives from its external audit firm. In each of these prominent financial statement fraud cases, key corporate personnel responsible for financial reporting, such as the controller and/or chief financial officer (CFO), was hired from the company's external auditor. For example, at Waste Management every CFO and chief accounting officer in the company's history, up until it was forced to restate earnings, had previously worked for Arthur Andersen, the company's long-time audit firm (Grimsley 2002). Similarly, at Global Crossing, the company's vice president for finance had previously been the engagement partner on the account at Arthur Andersen (Jubak 2002). At Microstrategy Inc., the senior audit manager from PricewaterhouseCoopers, in violation of ethics rules, actively solicited a job as their CFO while still conducting the audit (Grimsley 2002). Similarly, the Royal Commission investigating the collapse of HIH Insurance has questioned the independence of that company's auditors given that three company directors, along with the chairman and CFO, had formerly worked for their audit firm (Elias 2001).¹This apparent sharing of personnel between companies committing financial fraud and their audit firms has given rise to a substantial amount of public and congressional criticism of the auditing and financial reporting community (Jubak 2002; US Senate Hearings 2002). Such an outcry has lead to the recently enacted Sarbanes-Oxley Act of 2002 (U.S. House of Representatives 2002) that includes a provision that expressly forbids public companies in the US from hiring senior financial reporting personnel from their external auditors for up to one year from the individual's departure from the audit firm. While such auditor/client employment restrictions have been debated and proposed in the past (c.f., AICPA 1978; Independence Standard Board (ISB) 2000; Pitt 2002), the new regulation is the first to specifically limit the "revolving door" by requiring a "cooling off period" prior to the employment of auditors by their clients.

It is clear from much of what has been written in relation to these types of employment practices that many commentators, legislators, and market participants perceive that audit independence may be impaired and that financial misrepresentation may be more prevalent in these situations (Imhoff 1978; ISB 2000). As noted numerous times by the public accounting profession, financial statement user perceptions concerning auditor independence in both fact and appearance are key foundations of the auditing profession (Mednick 1997; Castellano 2002). The ISB has specifically noted that auditor independence is both "independence of mind" and "independence in appearance" (ISB 2001). When applying these concepts to the revolving door issue, the ISB has noted that "an audit firm's independence is impaired with respect to an audit client that employs a former firm professional who could, by reason of his/her knowledge of and relationship with the audit firm, adversely influence the quality or effectiveness of the audit" (ISB 2000, para. 1).

Most of the extant research into the revolving door (for example, Imhoff, 1978; Koh & Mahathevan, 1993; Parlin and Bartlett 1994; Kaplan and Whitecotton 2001) has focused on perceptions of CPAs and various financial statement users of whether auditor independence is diminished when an auditor accepts employment with a client, or whether fellow auditors would report individuals continuing to work on clients that have offered them employment. These studies indicate that auditors are reluctant to report violations of fellow auditors, and have consistently shown that financial statement users possess a negative view of the revolving door, especially when the professional leaving the audit firm is in a supervisory position and will be directly involved with the audit and/or financial statement preparation in their new position.

Notwithstanding these adverse perceptions of the revolving door, we are not aware of any published research that empirically examines whether this employment practice is associated with undesirable outcomes for corporate stakeholders. One such adverse outcome would be the excessive practice of earnings management.² The focus of our study is on earnings management because this practice is presently a major concern of investors and regulators in all securities markets (Collingwood 2001; Klein 2002) and is something under the direct control of these financial reporting individuals. Moreover, former auditors who are now employed with former clients in supervisory financial reporting roles are in a unique position to practice earnings management in these settings. Thus, our study addresses a gap in the literature by evaluating a sample of companies engaging in revolving door hiring practices with their external audit firm for evidence of earnings management. In essence, this study examines whether the restrictions on auditor employment recently enacted by congress in the Sarbanes-Oxley Act of 2002 are empirically justified.

The focus of our study is on firms where senior management with the authority and capability to influence external financial reporting (for example, the CFO, VP-Finance and Controller) are immediate former employees of the company's external auditor. We study this sample of companies for evidence of earnings management in the period immediately prior to the professional leaving the audit firm (i.e., when they may still be working on the audit), and the first two reporting years after joining the public company.

Our findings indicate evidence of significant earnings management using the cross-sectional version of the modified Jones (1991) discretionary accruals model by the sample of companies engaging in the revolving door hiring practices compared to two control groups of firms hiring non-auditor individuals and auditors from other CPA firms in financial reporting positions. These results are robust to additional tests undertaken to address the concerns of Dechow et al. (1995) and Young (1999) regarding the use of discretionary accrual models. Further tests indicate that earnings management is relatively evenly distributed among current accrual items, consistent with the findings of Christie and Zimmerman (1994). We find no evidence, however, that earnings management by these individuals has increased in recent years. Our overall results lend empirical support for congress's recent actions to restrict these revolving door hiring practices.

II. BACKGROUND

Regulation of the Revolving Door

The revolving door between public accounting firms and corporate clients has been of concern to the accounting profession and regulators for many years. The Cohen Commission's Report (AICPA 1978) advocated that accounting firms be barred from assisting their professionals in joining clients. In response to these and other concerns of the Commission, and after years of debate, the AICPA eventually issued an ethics ruling that limits an auditor's ability to simultaneously audit a company and entertain employment opportunities with them (AIPCA 1991). The ethics ruling requires that individuals remove themselves from attest engagements involving these companies until after the offer of employment is resolved. The ruling does not preclude auditors from entertaining or accepting offers of employment with clients. It does, however, indicate that to prevent the appearance that independence or objectivity may have been impaired, individuals cannot simultaneously audit a company and consider employment with them (AICPA 2001). Additionally, the ruling requires auditing firms to consider what, if any, additional procedures may be necessary to ensure that the work performed by these individuals with respect to that client prior to the offer of employment was performed with objectivity and integrity (AICPA 1991, 2001).

In 1993, the AICPA further suggested that the SEC prohibit audit partners from joining a client for one year following the partner's association with the audit. The SEC (1994) responded that it believed that rules for such a restriction on employment would be very difficult to operationalize and enforce and that they recommended that the AICPA examine this issue further. However, the SEC's chair, Arthur Levitt (1998) argued strongly that the accounting profession ought to better police itself, including establishing more guidelines on these questionable employment practices between companies and their auditors.

In July 2000, the ISB, charged with establishing guidelines to insure the independence of external audit firms, issued Independence Standard No.3, Employment with Audit Clients. The standard's requirements were effective for employment with audit client situations arising after December 31, 2000 and identified three primary threats to independence arising from the revolving door. First, audit team members who resign to accept positions with audit clients may not have exercised an appropriate level of skepticism during the audit process prior to their departure. This concern is perhaps most relevant to the year prior to changing positions where the professional is likely to have been negotiating with his/her potential employer. Second, the departing professional may be familiar enough with the audit approach and testing strategy so as to be able to circumvent them once he/she commences employment with the client. Third, remaining members of the audit firm who may have been friendly with, or respectful of, a former partner or other professional when he/she was with the firm, would be reluctant to challenge the decisions of that former colleague. As a consequence, these auditors might accept the client's proposed accounting without exercising appropriate skepticism or maintaining objectivity (ISB 2000).

Similar to the existing ethics ruling, this standard prescribed three pre-change in employment safeguards against potential independence impairment. First, professionals must promptly disclose to their firm, discussions between themselves and an audit client concerning potential employment. Second, auditors engaged in potential employment negotiations with a client are immediately transferred from the audit engagement. Third, upon withdrawal of an employee from the audit engagement, the firm analyses that person's work to judge whether he or she utilized appropriate skepticism while undertaking the audit engagement.

The standard also prescribed four post-change in employment safeguards. First, if an auditor accepts employment with the client, the on-going audit engagement team must give due attention to the suitability or need to modify the audit plan to allow for the increased risk of circumvention. Second, the firm should take pertinent steps to guarantee that the audit team has the standing and objectivity to effectively interact with the former employee and his or her work. Third, where a former auditor joins a client within one year of leaving the firm and that person has material contact with the audit team, the next annual audit is separately reviewed by an auditor from elsewhere in the firm to ascertain whether the engagement team maintained the appropriate skepticism when assessing the representations and work of a former employee. Fourth, the professional must settle all capital and/or retirement balances within five years of disassociating from the firm and the former firm professional must disclose in the company's proxy statement that he/she was formerly employed with the audit firm.

It should be noted that the ISB also considered a mandatory "cooling-off" period (i.e., a waiting period) for audit professionals before joining their clients. However, they decided not to require this for several reasons including difficulties in enforcement and specifying which types of professionals and what ranks should be included in such a rule. They also noted that companies benefit from the ability to hire staff at all levels from the audit team. The ISB was also concerned with the diminishing attractiveness of careers in CPA firms and felt that restricting future employment opportunities may have further negative connotations on the profession's ability to attract high quality individuals. These same arguments were presented by the SEC (2000) in their consideration and ultimate rejection of a mandatory "cooling-off" period during their reconsideration of auditor independence requirements.

Most recently, congress passed legislation in the wake of several high-profile bankruptcies and financial reporting frauds that included former auditors working for former clients (i.e., Enron, Waste Management, Microstrategy). The U.S. Congressional hearings emanating from the Enron collapse essentially lead to the adoption of the Sarbanes-Oxley Act of 2002 (U.S. House of Representatives 2002), which includes a section on auditor conflicts of interest which preclude revolving door employment practices. Specifically, the Act states that

"It shall be unlawful for a registered public accounting firm to perform for an issuer any audit service required by this title, if a chief executive officer, controller, chief financial officer, chief accounting officer, or any person serving in an equivalent position for the issuer, was employed by that registered independent public accounting firm and participated in any capacity in the audit of that issuer during the 1-year period preceding the date of the initiation of the audit"(Section 206).

This legislation is the first to specifically preclude auditors from immediately stepping into financial reporting roles at their former clients while maintaining their former audit firm employers as the company's auditor. Public companies potentially engaging in these employment practices must now decide between waiting to hire these individuals for one year and retaining their existing audit firm, or hiring the individual immediately and changing auditors. It remains to be seen how effective the SEC will be in enforcing these new rules imposed by congress in this new legislation, particularly in light of its prior hesitation to adopt similar rules.

Interestingly, some companies had already moved to voluntarily address this issue. For example, Cendant Corporation disclosed in its 2002 proxy statement that its board had adopted a new corporate governance requirement that would no longer allow the hire of employees from its auditor who participate in auditing the company's financial statements.

Advantages of the Revolving Door

While regulators and researchers have tended to focus on the potential adverse consequences of the revolving door, it should be recognized that there are also potential advantages of this activity. First, the possibility of being hired into a senior position by a former client may attract talented and ambitious recruits into the accounting profession (ISB 2001; POB 2000). Second, an auditor who has worked for several years on an engagement is thoroughly familiar with their client's systems and people, and brings a breadth of experience from a range of other audit clients. These skills are likely to prove valuable to companies in effectively discharging their financial responsibilities to investors. It is noteworthy that companies, in publicly announcing the hiring of key financial personnel, often highlight the prior audit experience of that individual in dealing with their company as a major reason for their recruitment.

There are also practical problems to consider in attempting to prohibit the revolving door. For example, a mandatory cooling off period as currently legislated would necessitate a client being forced to choose between an audit firm and its key audit personnel in some major hiring decisions. It should also be recognized that financial statement frauds that result from collusion between an auditor and their client are unlikely to be prevented by postponing their hire. For example, if the client wished to compensate an unscrupulous auditor for his/her role in a fraud, a hiring ban could be circumvented by using consulting contracts or other payments made to the audit professional following their resignation from the CPA firm (ISB 2000).

III. PRIOR RESEARCH AND HYPOTHESES

Prior Research on Auditor Employment by Clients

Studies (e.g., Imhoff 1978; Firth 1981; Schleifer and Shockley 1990) demonstrate that the revolving door is quite commonplace in industry, and that financial statement users, such as bankers and financial analysts, possess a high level of concern about its possible adverse implications for auditor independence.

The first study to specifically examine the incidence and perceptions of the revolving door was by Imhoff (1978). Utilizing a survey approach, he found that out of a sample of 258 audit professionals who resigned from their firm during a one-year period, 53 (20%) accepted a position with a client company, and 152 (59%) joined a non-client firm. Only 32 (12%) obtained a job with another CPA firm. Of the 53 who had joined a former client, 42 (79%) had directly worked on their clients' audit engagement.

Imhoff (1978) also compared the opinions of CPAs and financial statement users as to whether independence was affected when an auditor took a position with a client firm. In the questionnaire, a vignette was developed in which a CPA accepted a position with a client company that the CPA had previously audited. Two variables were studied. First, the level of the CPA while auditing the client (supervisory versus non-supervisory) and second, the time lag between working as an auditor of the client and accepting employment with them. His sample consisted of 110 of each of the following three groups: bankers, financial analysts and CPAs. He found that financial statement users (bankers and analysts) were more critical of these employment practices than were the CPAs. He also found that the shorter the time between leaving the CPA firm and joining the client, the greater the perceived lack of independence. CPAs felt that an audit supervisor could remain independent as long as the time interval was greater than 6 months, while users questioned the independence of the supervisor for up to 18 months after leaving the audit firm. When the auditor was in a non-supervisory capacity, all respondent groups only questioned independence in periods of less than 6 months.

Firth (1981) studied several aspects of the potential impact of auditor-client relationships on bank lending decisions. In one case, he examined an audit partner who was directly responsible for the audit of a client for 10 years prior to accepting a position as that company's finance director. He found that bankers' lending decisions were significantly adversely impacted by this relationship.

Schleifer and Shockley (1990) studied the perceptions of CPAs and financial statement users (stock analysts and bank loan officers) to a number of recommendations of the Cohen Commission (AICPA 1978) that aimed to enhance auditor independence. As indicated earlier, one of the suggestions of the Commission was that CPA firms be prohibited from assisting their former employees in obtaining work with audit clients. Bank loan officers concurred with this recommendation, however, partners in large CPA firms disagreed with the prohibition.

Koh and Mahathevan (1993) extended the work of Imhoff (1978) by evaluating the impact of two additional variables that may impact views on auditor independence: the type of audit opinion issued by the ex-auditor (clean versus qualified opinion), and the current position held by the ex-auditor in the client firm (financial statement preparer versus non-preparer). Subjects of their study were 45 middle managers of companies in an MBA class. Similar to Imhoff (1978), they found that independence concerns heightened as the time period between the last audit and joining the client company decreased. Independence concerns were found to be associated with the rank of the auditor when he/she resigned from the CPA firm and to his/her current position level with the client. Specifically, auditor independence was questioned more when the ex-auditor accepted a position as a financial statement preparer after issuing a clean opinion.

Parlin and Bartlett (1994), using a between-subjects experimental design, found that current year auditors established a larger preliminary estimate of materiality when the controller of the client company was a former colleague (manager of the audit) that was involved in the prior years audit. The authors interpret this finding of looser estimates for former colleagues as evidence of lack of independence in fact. While the study was conducted using a hypothetical company, transference of these results to actual audit clients would indicate that auditors might compromise independence on audits involving work with former colleagues.

Kaplan and Whitecotton (2001) have more recently extended research in this area to the likelihood of auditors reporting peers who violate the 1991 professional ethics ruling regarding auditing clients while simultaneously entertaining employment offers from them (AICPA 1991). In their between-subjects experiment they found that auditors (audit seniors) were generally not likely to report violating supervisors (audit managers), but that reporting was more likely if the perceived personal cost of reporting was low and the perceived personal responsibility for reporting was high. These results are consistent with Imhoff's (1978) contention that such self-policing policies regarding client employment opportunities and reporting nonconforming peers are difficult to enforce.

Company Executives and Earnings Management

Researchers (e.g., Ball and Brown 1968; Beaver et al. 1979; DeFond and Park 2001) have long documented a relation between earnings and stock prices. This relationship provides management with a strong incentive to manage earnings particularly where their remuneration is tied to stock price performance through bonuses and/or options (Healy 1985; Yermack 1997; Abdoody and Kasznik 2000). It is therefore not surprising that researchers have found evidence of accounting manipulations where corporate governance practices are weak (Beasley 1996; Carcello and Neal 2000; Klein 2002). Moreover, researchers have found evidence of earnings management in a variety of situations including changes in corporate control such as initial public offerings (IPOs) (Teoh et al. 1998a), management buy-outs (Perry and Williams 1994), smoothing earnings (Burgstahler and Dichev 1997; Byrnes et al. 1998; Pincus and Rajgopal 2002), debt covenant tightness (DeFond and Jiambalvo 1994) and meeting earnings forecasts (Beatty et al. 2002; Matsumoto 2002; Moehrle 2002).

Arthur Levitt, former Chair of the SEC observed that earnings management is a "widespread but too little challenged custom" (Collingwood, 2001, p.67). SEC investigations and congressional hearings into highly publicized instances of recent accounting irregularities such as WorldCom, Enron, Cendant, Adelphi and Sunbeam, substantiate reports of deliberate actions by management to manipulate reported earnings to obtain desirable corporate or personal outcomes

However, company executives may choose not to manage earnings. For earnings management to occur, the costs of undoing earnings management must exceed the costs of managing earnings (Watts & Zimmerman, 1990). It may be argued that the costs of earnings management are high. Firm managers and boards of directors possess a fiduciary duty to act in the best interests of stockholders. This fiduciary duty includes ensuring that reported earnings are free of material accounting manipulation. These fiduciary obligations can result in legal actions from disgruntled stakeholders such as investors when they believe that, as a consequence of managers' or directors' failures to appropriately discharge their duties, they suffered financial losses (Glater 2002). The present myriad of class action suites against parties involved with fraudulent corporations, including individual managers and directors, bears testament to the seriousness of these fiduciary duties (SEC 2002). Moreover, many investors such as mutual funds have the resources and expertise to evaluate the quality of financial statements issued by a public company.

However, earnings management, unlike financial statement fraud, involves the selection of accounting procedures and estimates that conform with generally accepted accounting procedures (Schipper 1989). It follows that earnings management by firms would be problematic for investors, and perhaps even auditors, to identify and prove. Nevertheless, with the present market focus on quality of earnings in the wake of recent accounting scandals, any suspicion of earnings management is likely to result in significant stock price declines and the loss of firm reputation.

With respect to the revolving door, former auditors who now work in an influential role over a company's financial reporting are in a unique position to practice earnings management. They are not only knowledgeable about specific reporting aspects for the company and industry, but also possess an intimate understanding of the audit techniques employed by their former audit firm to examine the amounts reported on the financial statements. Moreover, they personally know many of the current auditors and may have formerly been in a supervisory position over some, if not all, of these individual auditors (ISB 2000). Such knowledge and potential personal relationships may afford former auditors employed by public companies the ability to exercise earnings management practices with less likelihood of being discovered, challenged or corrected.

Hypotheses

Based on the above discussion, and the imposition of the employment restrictions contained in the Sarbanes-Oxley Act of 2002, we would expect more earnings management by companies who had recently hired financial reporting individuals from their CPA firm compared to peer companies not engaging in similar hiring practices. Thus our first hypothesis:

H₁ Companies that hire senior financial reporting personnel from their auditor are more likely to engage in earnings management in the periods immediately preceding and after their hire than similar companies not employing individuals from their auditor.

We also examine if earnings management by these individuals has become more prevalent in the recent years. Levitt (1998) has argued that the practice of earnings management has become more pervasive in recent years. However, this contention has also not been examined empirically. Accordingly, to examine whether earnings management practices by revolving door participants has increased over time, our second hypothesis:

H₂ Earnings management by companies hiring senior financial reporting personnel from their auditor has increased in more recent years.

IV. MEASUREMENT OF EARNINGS MANAGEMENT

Researchers (see, for example, Healy 1985; Dechow et al. 1996; Teoh et al. 1998a, b; DeGeorge et al. 1999) have employed numerous models to detect earnings management. In this study we utilize the widely applied (see, for example, Teoh et al. 1998a; Erickson and Wang 1999; Klein 2002) modified version of the Jones (1991) model to identify earnings management. In order to address criticisms by Dechow et al. (1995) that this model may misclassify some nondiscretionary accruals as discretionary accruals, we also conduct robustness tests consistent with Erickson and Wang (1999).

The modified Jones model identifies unexpected accounting accruals included in reported financial statement numbers. Unexpected accruals are used as a proxy for the discretionary component of reported earnings, namely, the extent to which earnings are managed (Dechow and Skinner 2000). Studies such as Teoh et al. (1998a, b) dissect discretionary accruals into current and non-current components. However, researchers (c.f. Christie and Zimmerman 1994) have found that earnings management is mainly concentrated in current asset and liability (working capital) items such as accounts receivable and payable. These findings are not surprising as management has more discretion to manipulate earnings through items that support day-to-day operations (Guenther 1994). For example, earnings can be manipulated upwards through short-term items such as bringing forward credit sales, delaying recognition of expenses through assumption of a low bad debts provision, or by deferring recognition of expenses. Long-term accrual adjustments, which involve long-term net assets, can be increased by decelerating depreciation, decreasing deferred taxes (the difference between tax expense and actual tax owed), or realizing unusual or "one-time" gains (Teoh et al. 1998a). These long-term items are difficult to conceal from users of financial statements, as they generally require specific disclosures. Accordingly, we assess both total and current accruals in our study.

Annual Discretionary Current Accruals

We start by calculating the annual discretionary current accruals for our sample using the same approach as Teoh et al. (1998a, b) and Easterwood (1998) as follows:

ACA _{i, t} = (CTCA _{i, t} - CCASH _{i, t}) - (CTCLIA _{i, t} - CCDEBT _{i, t}) (1)

where: ACA _{i, t} = annual current accrual for firm i at year t; CTCA _{i, t} = change in total current assets for firm i at year t; CCASH _{i, t} change in cash for firm i at year t; CTCLIA _{i, t} = change in total current liabilities for firm i at year t; CCDEBT _{i, t} = change in short-term debt & current maturities of long-term debt for firm i at year t.

The annual current accrual is composed of a nondiscretionary component and a discretionary component. The discretionary component is the measure of earnings management and is calculated as follows:

DACA _{i, t} = ACA _{i, t} - NDCA _{i, t} (2)

where: DACA _{i, t} = discretionary annual current accrual for firm i at year t; NDCA _{i, t} = nondiscretionary annual current accrual for firm i at year t. This latter variable is an estimate of what ACA _{i, t} would be absent earnings management.

We then determine discretionary current accruals by the cross-sectional version of the modified Jones (1991) accruals estimation model as reported in Dechow et al. (1995). Subramanyam (1996) finds that cross-sectional Jones models are generally better specified than their time series counterparts. Our cross-sectional regression uses all Compustat firms in the same two-digit SIC code as the control (Teoh et al., 1998b). Differences between discretionary and nondiscretionary accruals are calculated in a two-stage process. First, the following OLS regression model is used to estimate nondiscretionary current accruals for industry i:

ACA _{i, t} / TA_{i, t-1} = _i [1/TA_{i, t-1}] + _1i [(CREV_{i, t} - CAR _{i, t}) / TA _{i, t-1}] + _{i, t} (3)

where: TA_{i, t-1} = total assets for firm i at year t-1 (prior year total assets); CREV_{i, t} = the change in revenues for firm i during year t; CAR _{i, t} = the change in accounts receivable for firm i during year t.

All terms in equation (3) are scaled by lagged total assets to control for heteroscedasticity. Like prior studies, CREV_{i, t} and CAR _{i, t} are designed to control for the expected components in total accruals as current accruals are expected to increase with revenues (Dechow et al. 1995). In this study, sales are adjusted for changes in accounts receivable throughout the estimation period as well as the event period to maintain consistency between the two periods.

Coefficient estimates obtained from equation (3) are used to calculate DACA_{i, t}, the prediction error, as follows:

DACA_{i, t} = ACA _{i, t} / TA_{i, t-1} - (a_i [1/TA_{i, t-1}] + _1i[(CREV_{i, t} - CAR _{i, t})/TA _{i, t-1}] (4)

Annual Discretionary Total Accruals

In addition to discretionary current accruals, we also assess discretionary total accruals. We start by calculating the total annual accruals for our sample as follows:

ATC _{i, t} = (CTCA _{i, t} - CCASH _{i, t}) - (CTCLIA _{i, t} - CCDEBT _{i, t}) - DEPR _{i, t} (5)

where: ATC _{i, t} = annual total accruals for firm i at year t and DEPR _{i, t} = depreciation expense for firm i at year t.

The annual total accrual is comprised of a nondiscretionary and a discretionary component. The discretionary component is the measure of earnings management and is calculated as follows:

DATC _{i, t} = ATC _{i, t} - NDATC _{i, t} (6)

where: DATC _{i, t} = discretionary annual total accrual for firm i at year t; NDATC _{i, t} = nondiscretionary annual total accrual for firm i at year t. This latter variable is an estimate of what ATC _{i, t} would be absent earnings management.

Ordinary least squares is used to estimate the following model for each firm:

ATC _{i, t} / TA_{i, t-1} = _i [1/TA_{i, t-1}] + _1i [(CREV_{i, t} - CAR _{i, t}) / TA _{i, t-1}] + _2i [GPPE_{i, t} / TA_{i, t-1}] (7)

where: GPPE_{i, t} = gross fixed assets for firm i at year t. The term, GPPE_{i, t}, is included in the model as depreciation accruals are anticipated to increase with property, plant and equipment (Dechow et al., 1995). Coefficient estimates obtained from (7) are used to calculate DTAC_{i, t}, the prediction error, as follows:

DTAC_{i, t} = ATC _{i, t} / TA_{i, t-1} - (a_i [1/TA_{i, t-1}] + _1i[(CREV_{i, t} - CAR _{i, t})/ TA _{i, t-1}] + _2i

[GPPE_{i, t} / TA_{i, t-1}] (8)

Earnings Management Period

This study tests whether companies manage earnings around the time of hiring key financial reporting personnel such as CFOs, VPs of Finance and Controllers from their auditors. Specifically, we examine the year immediately preceding (time t-1), the year the executive joined the company (time t)³ and the subsequent year (t+1). We examine the years closest in calendar time to the new appointment because this is when the new executive is in the best position to exploit his/her past relationships with the audit team and/ or knowledge of the audit techniques they employ. Moreover, the quality of earnings in the year preceding the hiring may be in question given that the new executive may have already been contemplating or negotiating with the client at that time, thus potentially compromising audit independence prior to their hire. These time periods are consistent with the concerns raised by the AICPA (1991) and ISB (2000) relating to the hiring of an individual from the company's auditor.

V. SAMPLE SELECTION

The focus of our study is on companies where a senior financial reporting executive such as a CFO, VP-Finance or Controller joined the company from their auditor in the eleven-year period 1989 to 1999. Moreover, we only include professionals who were at manager or partner level in the audit firm prior to leaving. The experimental sample group (hereafter termed "the auditor-firm relation" group) consists of only those cases where the audit professional gets hired immediately⁴into a senior financial reporting role at the client company. Cases where the time from leaving the audit firm to joining the client company is more than one year were deleted. We also excluded cases where the former auditor was employed by another company prior to their hire by a former client firm. These exclusions are consistent with the types of employment changes that the ISB (2000) considers to be of most threat to auditor independence and also allows us to more directly address what is now forbidden by the Sarbanes-Oxley Act of 2002.

In order to assess whether companies hiring individuals from their former auditor practice excessive earnings management, we compare these companies to their respective industries using the cross-sectional modified Jones model, as well as to two more specific control groups. The first control group (hereafter termed "non-auditor" group) is where the newly hired executive did not previously work as an auditor immediately prior to their hire by the company. This group represents individuals joining companies from ranks outside of public accounting. In order to control for the possible public accounting general knowledge effect, the second control group (hereafter termed "the auditor no-firm relation" group) is where the newly hired financial reporting executive previously worked for an audit firm other than the company's auditor immediately prior to their hire. The primary difference between our experimental sample and control groups is whether the company hired the individual from: 1) their existing audit firm, 2) a non-audit firm, or 3) an audit firm different than their current auditor. As indicated below, we use identical search strategies to obtain our experimental and control groups.

To identify newly hired individuals we started by conducting a full search of the Dow Jones Interactive database for each of the key words, "CFO", "Controller," "Vice President - Finance," or "Chief Accounting Officer." We chose these job titles for searches because these are indicative of executives in pivotal financial reporting positions that can influence the information reported on the financial statements, and they are the titles specifically listed in the Sarbanes-Oxley Act of 2002.

In formulating our samples we confined our analysis to NYSE or AMEX firms to ensure that we could obtain the appropriate financial data to run our earnings management model. To be consistent with other earnings management studies, we also excluded financial services and utilities industry firms operating in these industries (SIC codes 6000-6999 and 4900-4999).

We initially identified 1,128 individuals hired into financial reporting positions during the 1989-1999 time period. Of these, we identified 129 experimental sample companies hiring individuals directly from their existing audit firm (as reported in Compustat) that included all necessary employment and financial statement data. To derive our first control group of matched non-auditor hires, we identified individuals who were hired into these companies from non-CPA firms and matched them to our auditor-firm relation individuals in our experimental sample based on year of hire (within +/- 1 year of the hiring of the sample individual), then title (CFO, Controller, etc), then two-digit SIC code, and finally total assets. We could not find adequate matches for 13 of our 129 experimental sample company hires, leaving a final sample of 116 auditor-firm relation hires and 116 matched, non-auditor hires.⁵

Our search procedures also identified 73 hires of financial reporting individuals coming from CPA firms that were not the company's existing external auditor. Companies hiring these individuals were used as the second control group - the auditor no-firm relation group. Due to the smaller sample size, however, these individuals were not matched to our experimental group. All 73 companies were included in the analyses as the second control group. This final group controls for the general auditor knowledge effect that might be expected to exist when hiring any external auditor, even though they did not work for company's incumbent audit firm.

VI. RESULTS

Sample Distribution and Descriptive Statistics

Panel A of Table 1 outlines the total number of sample and control firms by year and group. This panel shows a relatively even spread of our sample firms across the period 1989 to 1999 with the annual numbers being slightly greater from 1993 onwards. Panel B shows that the two-digit SIC codes relating to the manufacturing sector comprises around 50% of our experimental and matched non-auditor control sample, with slightly higher percentages of the non-matched auditor no-firm relation control group in the services sector⁶ Panel C illustrates a very even distribution of our sample across the Big 5 accounting firms for the two groups of individuals coming directly from public accounting.

Table 2 presents summary descriptive statistics for our experimental and control samples. This table indicates that the companies comprising all three groups were relatively large (mean net sales of $1,050, 1,042, and $1,782 million, respectively) and that there were no significant differences between the two control groups and the auditor-firm relation group in terms of size, financial leverage or cash flows.

Tests for H₁

Since incentives to manage earnings in any one year appear to be relatively randomly distributed among firms (Healy and Wahlen 2000), prior studies (c.f., Warfield et al. 1995; Becker et al. 1998; Bartov et al. 2000; Klein 2002) have used the absolute value of abnormal accruals as an indication of earnings management for a particular firm in any given year. Similar to findings in these earlier studies, the mean (median) total abnormal accruals for our experimental sample of audit-relation firms is -0.003 (0.000). Testing for whether these average (median) results are different from zero yields a p-value of .784 (.999). Further, fifty-one percent of the abnormal accruals for the experimental group are positive.⁷Thus, no evidence of an overall systematic upward or downward earnings management is evident in our experimental sample of firms. Accordingly, consistent with prior research, we use the absolute value of abnormal accruals to assess earnings management in our study.

In order to test our first hypothesis, the first two columns of Table 3 indicate the absolute total and current discretionary accruals (mean and median) for the auditor-firm relation experimental sample. This table indicates that total and current absolute accruals are easily significantly different from zero at times t-1, t and t+1 (p<.001 for all comparisons). These findings suggest that the auditor-firm relation firms are systematically managing earnings around the time of the professional changing employment through the use of financial accruals since the absolute discretionary accruals are non-zero. Hypothesis one is therefore supported for this initial analysis.

To more accurately assess our first hypothesis, we compare the results from the auditor-firm relation sample to the two control samples. The second set of columns in Table 3 presents the total and current absolute abnormal accruals for the matched non-auditor control group. While these values for all time periods are also non-zero (p<.001), when we compare these results to those of the auditor-firm relation group, we find significant differences between the two groups for the accruals in time t. Table 3 indicates that the mean total accruals and mean (median) current accruals between these matched groups are significantly different, with the auditor-firm relation companies exhibiting higher levels of absolute discretionary accruals in the initial year of hire.

Table 4 presents the results of comparing the auditor-firm relation group to the second control sample of 73 non-matched auditor no-firm relation group. Results from this comparison are consistent with those presented in the previous table. Absolute discretionary accruals are all significantly greater than zero (p<.001) for this control group, but are also different from the auditor-firm relation group at time t. The mean (median) absolute total and absolute current discretionary accruals are both different between these two groups at time t.

In order to assess our experimental and two control groups simultaneously, we ran unbalanced ANOVAs using the absolute values of discretionary accruals as the dependent variables and sample group as the classification variable. The results presented in Table 5 indicate that the absolute current and absolute total discretionary accruals are different between the three groups (p<.008 and .026, respectively). Subsequent group comparisons indicate, in Panel B, that the two control groups are similar in terms of absolute discretionary current accruals, but lower than the auditor-firm relation experimental group with respect to level of absolute discretionary current accruals (p<.05). Comparisons between groups on absolute discretionary total accruals in Panel C indicate that the auditor-firm relation group is higher than the non-matched firms with no-auditor relation (p<.05). However, the other comparisons indicate no significant differences between groups on mean total absolute discretionary accruals.

These collective results are generally consistent with H_1, that companies hiring CFOs and similar financial reporting executives directly from their audit firms exhibit significantly higher absolute discretionary accruals at time t compared to firms hiring similar individuals from sources other than their auditors. This is particularly true with respect to current accruals, which are more easily manipulated in the short-run.

However, while a concern of the AICPA and the SEC, we do not find any support for the argument that excess accruals might also exist in the year prior to hiring the individual from their auditor while they might still be on the engagement. Results from time t-1 analyses compared to the control groups are all nonsignificant, indicating no evidence of excessive earnings management prior to the employ of these former auditors.

Tests for H₂

In order to test our second hypothesis, our sample data is partitioned into early and late hires in two ways. Panel A of Table 6 splits the data based on the median year of the 11-year sample period - which occurs in 1994; Panel B splits the data in half based on the size of the auditor-firm relation sample (n=116) which occurs in 1996. These two partitioning techniques result in the comparison of sub-sample periods of 1989-1994 (n=46) vs 1995-1999 (n=70) and 1989-1995 (n=57) vs 1996-1999 (n=59). Both Panel A and B report that there is no statistically significant difference in terms of total or current absolute discretionary accruals between the sub-sample time periods in any of the mean (median) comparisons. Hypothesis two is therefore not supported. While there may appear have been an increase in the number of audit firm hires by companies in more recent times, there does not appear to be any significant increase in the amount of earnings management in the more recent years by companies hiring financial reporting individuals from their auditors.

Extensions and robustness tests

Dechow et al. (1995) demonstrate that accrual models may be mis-specified when applied to samples with extreme financial performance. This factor could impact the conclusions of our accrual tests if there are fundamental changes in firms' business operations around the period of the executive changes. In order to gain assurance that the positive unexpected accruals in our study are not due to extreme performance, we adopt the procedure utilized by Erickson and Wang (1999). This approach compares changes in revenues between event and non-event periods for all groups and between auditor-firm relation and the two control samples for the event period.

Table 7 reports the results of our analysis. We find no significant (p<.05) differences in changes in revenue between the event and non-event periods for all three groups used in our study. We also find nonsignificant mean and median differences between our experimental auditor-firm relation group and 1) the matched non-auditor group and 2) the auditor no-firm relation groups for the event period. These overall findings do not suggest that extreme financial performance is significantly affecting our results.

Given our finding of significant differences in current discretionary accruals for our sample, we conducted additional tests to identify which working capital items most explained this result. These are reported in Table 8. A cross-sectional model was developed for each working capital component to determine individual discretionary accruals. Table 8 indicates a significant difference in discretionary current accruals components between our two matched groups only for the means of the "other current liabilities" item, but not for the medians.⁸ Further, our experimental audit-firm relation sample exhibits higher absolute discretionary accruals (both mean and median) in all but the median of the "other current assets" item compared to the matched non-auditor group. All other individual component comparisons indicate no significant differences at time t. These findings suggest that managers were managing earnings fairly consistently across all current asset and liability components. It appears that it is not just one item, but the `sum of the parts' that creates the overall significance in assessing the absolute current discretionary accruals.⁹We also partitioned the data to see if discretionary accruals for companies audited by any particular Big 5 firm were significant when compared to the balance of our sample. Our findings do not suggest any significant differences based on specific accounting firms, so these results are not reported. However, we note that our results do not appear to be driven by companies hiring individuals from any one accounting firm.

VII. CONCLUSIONS

The present study investigated a sample of 116 companies where newly hired financial reporting professionals were formerly employed as managers or partners at the company's audit firm. Using the cross-sectional Jones (1991) model we find evidence of earnings management by this group for the initial year of hire. Our comparisons of the results from this group to a control group of 116 matched non-auditor hires, and a control group of 73 non-matched individuals hired from other audit firms supports our first hypothesis. Companies hiring financial reporting individuals directly from their auditors exhibited significantly higher total and current absolute abnormal accruals than the two control groups in the first year of hire.

Thus, our results provide some support for the Sarbanes-Oxley Act of 2002's ban on hiring financial reporting executives directly from the company's auditor. While we did not assess the potential effect of the one-year "cooling off" period prescribed in the Act, we do find evidence that individuals hired directly from the company's audit firm have engaged in earnings management as manifest in levels of total and, in particular, current absolute discretionary accruals.

However, we do not find support for the contention that the "revolving door" is more of a problem now than it used to be. Based on several partitions of our sample period, we do not find any evidence that more recent hires are engaging in any higher levels of earnings management than their counterparts from years ago. Thus, we find no empirical support for Levitt's (1998) contention that earnings management by former auditors has increased in more recent years.

Our results have implications for investors, companies, regulators, and the auditing profession. Investors may need to be more skeptical about the quality of reported financial information where recently hired senior financial executives (such as the CFO, VP-Finance or Controller) previously were employed by the company's audit firm. Likewise, company boards, especially their Audit Committees, will also need to question the accuracy of their externally reported data where these prior relationships exist.

Our findings are consistent with the concerns of regulators about the revolving door and support their recent actions to ban these transfers for a one-year period after the professional conducts the audit. The auditing profession will need to recognize the auditor independence implications arising from audits conducted on clients hiring former colleagues. While we find no evidence of earnings management at time t-1 (a period questioned by the AICPA and in the ISB's statement on employment with audit clients), time t certainly appears to be at risk. This extra risk should be factored into audit plans in cases involving these relationships, possibly even after the one-year waiting period called for in the Sarbanes-Oxley Act. Accordingly, future research should assess whether the mandatory one-year waiting period: (1) significantly deters this employment activity, and (2) reduces the level of earnings management associated with financial statements immediately after individuals are hired after their one-year waiting period.

As in all empirical research, there are several limitations to our study. First, a potential bias exists if SIC codes are not the appropriate definition of an industry to benchmark the efficient accounting choice set for our sample firms. Second, while we have undertaken robustness tests to address concerns about misspecifications by discretionary accruals models in cases of extreme financial performance, we recognize that widely applied accrual models such as the modified Jones (1991) model are not perfect detectors of earnings management. Third, we cannot be sure that some firms in our cross-sectional comparison do not also have a senior executive who recently switched from the audit firm that has not been publicly disclosed their backgrounds. However, to the extent that this is true, such non-identification of these individuals would bias our findings against being significant. Finally, we cannot be sure that the professionals who left the audit firm were working directly on the audit of that client prior to leaving. However, given these executives were very senior at the audit firm prior to leaving (managers or partners), and studies such as Imhoff (1978) show that the soliciting of individual auditors by audit clients is very common, it is likely that a large majority of our sample were auditors of their new employers, or at a minimum, were aware of their former audit firm's audit approach and how to use knowledge of the audit approach to effectively engage in earnings management techniques.

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Table 1 - Sample Distribution by Event-Year, Industry, and Accounting Firm Affiliation

Descriptive statistics for sample firms. The auditor-firm relation firms are the firms where the newly hired manager worked for the sample firms' auditor immediately before being hired by the sample firm. The matched non-auditor firms are the firms where the newly hired manager did not work for the sample firms' auditor or any other auditor immediately prior to being hired. The non-matched auditor no-firm relation firms are the firms where the newly hired manager did not work for the sample firms' auditor, but worked for a different public auditing firm immediately before being hired.

Panel A: Sample Distribution By Event-Year

Event-year	Auditor-firm relation firms	Matched non- auditor firms	Non-matched auditor no-firm relation firms
1989	6 (5.2%)	4 (3.4%)	5 (6.9%)
1990	3 (2.6%)	4 (3.4%)	8 (10.9%)
1991	9 (7.8%)	8 (6.9%)	8 (10.9%)
1992	10 (8.6%)	7 (6.0%)	7 (9.6%)
1993	6 (5.2%)	8 (6.9%)	6 (8.2%)
1994	12 (10.3%)	11 (9.5%)	8 (10.9%)
1995	11 (9.5%)	13 (11.2%)	8 (10.9%)
1996	19 (16.4%)	19 (16.4%)	5 (6.9%)
1997	20 (17.2%)	21 (18.1%)	8 (10.9%)
1998	12 (10.3%)	11 (9.5%)	5 (6.9%)
1999	8 (6.9%)	10 (8.6%)	5 (6.9%)
Total	116	116	73

Panel B: Sample Distribution By Two Digit SIC Industry

SIC codes	Industry	Auditor-firm relation firms	Matched non- auditor firms	auditor no-firm relation firms
10 - 19	Mining & Construction	4 (3.4%)	4 (3.4%)	4 (5.5%)
20 - 39	Manufacturing	64 (55.2%)	64 (55.2%)	28 (38.4%)
40 - 49	Transportation and Utilities	5 (4.3%)	5 (4.3%)	7 (9.6%)
50 - 59	Wholesale and Retail	18 (15.5%)	18 (15.5%)	9 (12.3%)
70 - 89	Services	25 (21.6%)	25 (21.6%)	25 (34.2%)
	Total	116	116	73

Panel C: Sample Distribution By Audit Firm Affiliation

Accounting Firm	Auditor-firm relation firms	Non-matched auditor no-firm relation firms
Arthur Anderson	18 (15.5%)	11 (15.1%)
Deloitte and Touche	18 (15.5%)	12 (16.4%)
Ernst & Young	30 (25.9%)	13 (17.8%)
KPMG	21 (18.1%)	12 (16.4%)
PriceWaterhouseCooper	24 (20.7%)	19 (26.0%)
Others	5 (4.3%)	6 (8.2%)
Total	116	73

Table 2 - Descriptive Statistics

Descriptive statistics for sample firms. The auditor-firm relation firms are the firms where the newly hired manager worked for the sample firms' auditor immediately before being hired by the sample firm. The matched non-auditor firms are the firms where the newly hired manager did not work for the sample firms' auditor or any other auditor immediately prior to being hired. The non-matched auditor no-firm relation firms are the firms where the newly hired manager did not work for the sample firms' auditor, but worked for a different public auditing firm immediately before being hired.

Panel A: Firms with an auditor-firm relationship (n = 116)

	Mean	Median	Std. Dev.	Minimum	Maximum
Net Sales ($ mil.)	1,049.8	186.5	2,578.3	1.0	20,012.0
Total Assets ($ mil.)	1,119.3	194.6	2,755.8	8.2	17,982.7
Long-term Debt / Total Asset	0.169	0.095	0.199	0.000	0.864
Operating Cash Flow / Total Assets	0.026	0.058	0.164	-0.694	0.315

Panel B: Matched non-auditor firms (n = 116)

	Mean	Median	Std. Dev.	Minimum	Maximum
Net Sales ($ mil.)	1,041.9	193.2	2,2290.8	1.5	17,719.9
Total Assets ($ mil.)	850.8	162.8	1,640.0	6.1	12,431.0
Long-term Debt / Total Asset	0.161	0.109	0.162	0.000	0.892
Operating Cash Flow / Total Assets	0.019	0.047	0.170	-0.927	0.306

Panel C: Non-matched auditor no-firm relationship (n = 73)

	Mean	Median	Std. Dev.	Minimum	Maximum
Net Sales ($ mil.)	1,781.9	151.8	6,617.1	0.7	52,344.0
Total Assets ($ mil.)	1,969.1	151.4	9,789.1	2.6	83,533.1
Long-term Debt / Total Asset	0.173	0.133	0.187	0.000	0.833
Operating Cash Flow / Total Assets	0.021	0.061	0.199	-0.771	0.282

Note - Net sales, total assets, long-term debt/total assets, ad operating cash flow/total assets are annual figures from the fiscal year report for the year the manager was hired (time t). Tests for differences in means were calculated using a t-test assuming unequal variances while differences in medians where calculated using a Wilcoxon signed-rank test. In comparing the firms with an auditor-relation to the matched non-auditor firm group, and to the non-matched auditor no-firm relation group, the differences in means and medians for all four financial variables are not significantly different from zero.

Table 3 - Absolute Discretionary Accruals: Auditor-firm relation vs. Matched non-auditor firms

Discretionary accruals are the absolute value of discretionary accruals as a percent of total assets. The auditor-firm relation firms are the firms where the newly hired manager worked for the sample firms' auditor immediately before being hired by the sample firm. The matched non-auditor firms are the firms where the newly hired manager did not work for the sample firms' auditor or any other auditor immediately prior to getting hired by the sample firm.

Absolute Discretionary Accruals

(0.643)

		Auditor-firm relation firms (n = 116)		Matched non-auditor firms (n = 116)
		Mean	Median	Mean	Median	Difference in Means	Difference in Medians
Time (t-1)
Total Accruals	0.1118	0.0586	0.1036	0.0572	0.0081	0.0014 (0.674)
Current Accruals	0.1004	0.0543	0.0101	0.0568	0.0001 (0.994)	-0.0025 (0.681)
Time (t)
Total Accruals	0.1103	0.0785	0.0869	0.0590	0.0233** (0.045)	0.0195 (0.255)
Current Accruals	0.1020	0.0721	0.0764	0.0514	0.0256** (0.024)	0.0207** (0.044)
Time (t+1)
Total Accruals	0.0913	0.0605	0.0876	0.0696	0.0038 (0.723)	-0.0091 (0.948)
Current Accruals	0.0831	0.0564	0.0786	0.0550	0.0045 (0.656)	0.0014 (0.986)

^*** Denotes significance at the 1% level.

^** Denotes significance at the 5% level.

^* Denotes significance at the 10% level.

Note A - P-values are in parentheses. P-values for differences in means are calculated using a t-test assuming unequal variances while differences in medians are calculated using a Wilcoxon signed-rank test.

Note B - All individual t-tests for all abnormal accruals (total and current) being different from zero for both samples at all three time periods are significant at the 99.9% level, and, accordingly, are not reported separately. By definition, all absolute discretionary accruals are positive, so it is unnecessary to do a sign test for differences in medians compared to zero.

Table 4 - Absolute Discretionary Accruals: Auditor-firm relation vs. Non-matched auditor no-firm relation

Discretionary accruals are the absolute value of discretionary accruals as a percent of total assets. The auditor-firm relation firms are the firms where the newly hired manager worked for the sample firms' auditor immediately before being hired by the sample firm. The non-matched auditor no-firm relation firms are the firms where the newly hired manager did not work for the sample firms' auditor, but worked for a large public auditing firm immediately before being hired.

Absolute Discretionary Accruals

	Auditor-firm relation firms (n = 116)		Non-matched auditor no-firm relation firms (n = 73)
	Mean	Median	Mean	Median	Difference in Means	Difference in Medians
Time (t-1)
Total Accruals	0.1118	0.0586	0.1092	0.0536	0.0027 (0.898)	0.0050 (0.735)
Current Accruals	0.1004	0.0543	0.0965	0.0509	0.0040 (0.828)	0.0034 (0.988)
Time (t)
Total Accruals	0.1103	0.0785	0.0761	0.0460	0.0342** (0.018)	0.0325** (0.021)
Current Accruals	0.1020	0.0721	0.0651	0.0382	0.0368*** (0.007)	0.0339*** (0.003)
Time (t+1)
Total Accruals	0.0913	0.0605	0.0768	0.0523	0.0146 (0.239)	0.0082 (0.273)
Current Accruals	0.0831	0.0564	0.0716	0.0410	0.0115 (0.323)	0.0154 (0.307)

^*** Denotes significance at the 1% level.

^** Denotes significance at the 5% level.

^* Denotes significance at the 10% level.

Note A - P-values are in parentheses. P-values for differences in means are calculated using a t-test assuming unequal variances while differences in medians are calculated using a Wilcoxon signed-rank test.

Note B - All individual t-tests for all abnormal accruals (total and current) being different from zero for both samples at all three time periods are significant at the 99.9% level, and, accordingly, are not reported separately. By definition, all absolute discretionary accruals are positive, so it is unnecessary to do a sign test for differences in medians compared to zero.

Table 5 - ANOVA Results

Discretionary accruals are the absolute value of discretionary accruals as a percent of total assets. The auditor-firm relation firms are the firms where the newly hired manager worked for the sample firms' auditor immediately before being hired by the sample firm. . The matched non-auditor firms are the firms where the newly hired manager did not work for the sample firms' auditor or any other auditor immediately prior to getting hired by the sample firm. The non-matched auditor no-firm relation firms are the firms where the newly hired manager did not work for the sample firms' auditor, but worked for a large public auditing firm immediately before being hired.

Panel A: Absolute Discretionary Accruals

		Current Accruals		Total Accruals
Time (t)	Sample	Mean	Std. Dev.	Mean	Std. Dev.
Firms with an auditor-firm relation	116	0.1020	0.0951	0.1103	0.1038
Matched non-auditor firms	116	0.0764	0.0750	0.0869	0.0772
Non-matched firms with no-auditor firm relation	73	0.0651	0.7989	0.0761	0.0832

Panel B: ANOVA Table for Absolute Discretionary Current Accruals Time (t)

ANOVA Table
	SS	df	MS	F	Prob > F
Between groups	0.0696	2	0.0348	4.89	0.008***
Within groups	2.1332	302	0.0071
Total	2.2028	304	0.0073
Comparison by group (Bonferroni)
		Firms with an auditor-firm relation		Matched non-audit firms
Matched non-audit firms		-0.0255** (0.049)
Non-matched firms with no-auditor firm relation		-0.0368** (0.011)		-0.0113 (1.000)

Panel C: ANOVA Table for Absolute Discretionary Total Accruals Time (t)

ANOVA Table
	SS	df	F	Prob > F
Between groups	0.0593	2	3.69	0.0261**
Within groups	2.4019	302
Total	2.4612	304
Comparison by group (Bonferroni)
	Firms with an auditor-firm relation		Matched non-audit firms
Matched non-auditor firms	-0.0232 (0.151)
Non-matched firms with no-auditor firm relation	-0.0341** (0.034)		-0.0109 (1.000)

^*** Denotes significance at the 1% level.

^** Denotes significance at the 5% level.

^* Denotes significance at the 10% level.

Table 6 - Discretionary Accruals: Comparison of Sample Over Sub-periods

Absolute discretionary accruals are absolute discretionary accruals as a percent of total assets. The table shows total and current absolute discretionary accruals for time t, split by event-year sub-periods.

Panel A: Absolute discretionary accruals for sample firms: 1989-1994 vs. 1995-1999

	Auditor-firm relation firms 1989-1994 (n=46)		Auditor-firm relation firms 1995-1999 (n=70)
	Mean	Median	Mean	Median	Difference in Means	Difference in Medians
Total Accruals	0.1039	0.0675	0.1143	0.0806	-0.0104 (0.600)	-0.0131 (0.863)
Current Accruals	0.0969	0.0665	0.1052	0.0811	-0.0083 (0.649)	-0.0146 (0.892)

Panel B: Absolute discretionary accruals for sample firms: 1989-1995 vs. 1996-1999

	Auditor-firm relation firms 1989-1995 (n=57)		Auditor-firm relation firms 1996-1999 (n=59)
	Mean	Median	Mean	Median	Difference in Means	Difference in Medians
Total Accruals	0.1090	0.0728	0.1114	0.0808	-0.0024 (0.902)	-0.0080 (0.840)
Current Accruals	0.0990	0.0671	0.1047	0.0828	-0.0058 (0.747)	-0.0157 (0.768)

Note - P-values are in parentheses. P-values for differences in means are calculated using a t-test assuming unequal variances while differences in medians are calculated using a Wilcoxon signed-rank test.

Table 7 - Robustness Test for Extreme Revenue Changes