ADIAC-00216; No of Pages 14 Advances in Accounting, incorporating Advances in International Accounting xxx (2013) xxx–xxx Contents lists available at ScienceDirect Advances in Accounting, incorporating Advances in International Accounting journal homepage: www.elsevier.com/locate/adiac Mandatory audit partner rotation, audit market concentration, and audit quality: Evidence from China☆ Sati P Bandyopadhyay a,1, Changling Chen a,⁎, Yingmin Yu b,2 a b School of Accounting and Finance, University of Waterloo, 200 University Avenue West, Waterloo, Ontario N2L 3G1, Canada School of Accountancy, Central University of Finance and Economics, 39 College South Road, Haidian District, Beijing 100081, China a r t i c l e i n f o Available online xxxx JEL classification: M41 M42 Keywords: Mandatory audit partner rotation Audit market concentration Audit quality a b s t r a c t This research examines the audit quality consequences of China's mandatory audit partner rotation (MPR) regulation, which became effective in 2004 The rule requires firms to rotate signing audit partners of audit reports every five years We find that audit quality improves in the three years immediately following a client firm's MPR during the 2004–2011 period for a sample of 273 Chinese publicly listed firms Specifically, we find that the improvement is most pronounced in those Chinese provinces with both low levels of audit market concentration and low levels of legal development However, MPR does not improve audit quality in jurisdictions where legal conventions are more developed and/or where audit markets are highly concentrated with a handful of large audit firms dominating the market © 2013 Elsevier Ltd All rights reserved Introduction In this study we examine the effects of mandatory audit partner rotation (MPR) on audit quality Specifically, we look at the effects of MPR under varying audit market concentration (AMC) conditions in the Chinese audit market, where, starting in 2004, regulators required client firms to rotate audit partners every five years We find that MPR improves audit quality in provinces with low levels of AMC but not in provinces with high levels of AMC Our results suggest that the effectiveness of MPR policy on audit quality depends on the structure of the audit market Our research contributes to audit literature by relating two long-standing issues, namely, the consequence of MPR on audit quality, and the impact of AMC on audit quality Both these issues have recently re-entered the public debate in the USA (Public Company Accounting Oversight Board, 2011a) and the European Commission (EU) (2011) In the post-Enron era, several countries have mandated periodic rotation of the lead audit engagement partner and the concurring ☆ We thank the editor Philip Reckers and two anonymous referees for their insightful comments We also thank Xi Wu, Junsheng Zhang, and other workshop participants at the Central University of Finance and Economics This study is supported by the research grants from the “Project 211” Fund of the Central University of Finance and Economics, China and grants from the “2011 Synergetic Innovation” Key Project on “Development of Public Accounting Profession” of the Central University of Finance and Economics, China We also gratefully acknowledge the financial support from the Research Fellowship Program at the School of Accounting and Finance of the University of Waterloo ⁎ Corresponding author Tel.: +1 519 888 4567x35731; fax: +1 519 888 7562 E-mail addresses: bandy@uwaterloo.ca (S.P Bandyopadhyay), clchen@uwaterloo.ca (C Chen), yuym168@gmail.com (Y Yu) Tel.: +1 519 888 4567x32533; fax: +1 519 888 7562 Tel.: +86 10 62156441; fax: +86 10 62288114 reviewing partner in order to improve audit independence and thus audit quality For example, the Sarbanes–Oxley Act (henceforth SOX, 2002) mandates US audit partners to rotate their audit clients every five years, and the European Union requires audit firms to replace audit partners in charge of their clients that are Public Interest Entities every seven years Similar MPR requirements are also in vogue in Australia, China, Taiwan, and many other jurisdictions.3 The consequence of mandatory auditor rotation (at firm or partner level) on audit quality depends on the tradeoff of improvement in audit independence versus loss in client-specific audit experience (Kinney & McDaniel, 1996; Knapp, 1991; Mautz & Sharaf, 1961).4 On the one hand, a fresh look into the audit engagement by the rotated-in audit partner improves audit independence and thus the quality of the audit On the other hand, the rotated-in partner does not possess the client-specific expertise of the rotated-out partner, and this lack of experience could reduce audit quality The final effect of MPR on audit quality is an empirical issue determined by the tradeoff Empirical evidence on the relation between MPR and audit quality is mixed Studies based on the Taiwanese audit market indicate either no effect or a negative effect of MPR on audit quality (Chen, Lin, & Lin, 2008; Chi & Huang, Other countries adopting MPR include Singapore, Japan, United Kingdom, France, Spain, the Netherlands, and Germany (General Accounting Office 2003, Appendix V; Chi et al., 2009) These authors use the generic “auditor” term in their papers and not specify whether their arguments apply to audit firm or audit partner level These arguments apply equally well to both firm and partner level (Chen et al., 2008) DeAngelo (1981) defines audit quality as the joint probability that an auditor detects a breach of accounting standards and the probability that the auditor reports the breach MPR will likely decrease the probability of detecting a breach because of lost audit knowledge but increase the probability of reporting the breach 0882-6110/$ – see front matter © 2013 Elsevier Ltd All rights reserved http://dx.doi.org/10.1016/j.adiac.2013.12.001 Please cite this article as: Bandyopadhyay, S.P., et al., Mandatory audit partner rotation, audit market concentration, and audit quality: Evidence from China, Advances in Accounting, incorporating Advances in International Accounting (2013), http://dx.doi.org/10.1016/j.adiac.2013.12.001 S.P Bandyopadhyay et al / Advances in Accounting, incorporating Advances in International Accounting xxx (2013) xxx–xxx 2005; Chi, Huang, Liao, & Hong, 2009) In contrast, research based on the Australian audit market (Carey & Simnett, 2006) provides some evidence that MPR tends to enhance audit quality Experimental evidence (Dopuch, King, & Schwartz, 2001; Tan, 1995) also suggests that MPR improves audit quality Note that while the identity of audit partners is public information in Taiwan and Australia, and thus the effect of MPR on audit quality can be evaluated directly, this is not the case in many jurisdictions, including the USA Recently, the European Commission (EU) (2011) has expressed the view that the practice of MPR does not improve audit independence (and hence audit quality) The argument is that MPR does not remove the familiarity threat that might cloud audit judgment and reduce professional audit skepticism of a new (rotated-in) audit partner, who would not have incentives to take decisions that might cause the audit firm to lose a long-standing client firm Hence, new (replaced) audit partners “likely feel obliged to live with the decisions and agreements made by the former (rotated-out audit) partner; he/she may have little flexibility to reopen them” (European Commission (EU), 2011, page 17) On the basis of these arguments, European Commission (EU) (2011) proposes mandatory audit firm rotation (MFR) to replace MPR Consistent with the view of the European Commission (EU) (2011), the US Public Company Accounting Oversight Board (henceforth PCAOB) issued a concept release in August 2011 (PCAOB, 2011a) that also suggests MFR for US firms The accounting community, however, has generally opposed the proposal to replace MPR with MFR For example, a summary of responses to the MFR study by the General Accounting Office (GAO, 2004, Question 73) shows that about two-thirds of the respondents appear to believe that relative to potentially more costly MFR, MPR sufficiently achieves the intended benefits of taking a fresh look at the audit engagement by the rotated-in partner In their response letter to the PCAOB (PCAOB, 2011b), the International Federation of Accountants (henceforth IFAC) argues that “these changes [MPR] are still relatively new, and have not been in place sufficiently long enough to objectively assess their impact.” This IFAC response implies the need for further examination of the consequences of MPR In summary, while many in the professional accounting and audit community believe that MPR enhances audit quality, international regulators not seem to share that view Moreover, as discussed above, academic research provides mixed evidence on the impact of MPR on audit quality Responding to the call of IFAC for further research on the effects of MPR, we examine the relation between MPR and audit quality in the Chinese audit market to provide some insight into this contentious debate Also, in contrast to extant research, we consider the impact of regional variation in AMC, whose role has recently been highlighted in the foregoing MPR versus MFR deliberations For example, the Center for Audit Quality (henceforth CAQ) argues in its written statement (PCAOB, 2011c) to PCAOB's (2011a) concept release that many small audit firms will find the costs of periodic tendering, documentation and staffing associated with MFR too onerous and will be forced to “abandon their public practice and focus instead on private company audits” (PCAOB, 2011c, page 12) This suggests that abandonment of MPR for MFR could lead to a higher level of concentration of the Big audit firms in many public audit markets that are already considered highly concentrated by policymakers For example, European Commission (EU) (2011) has expressed concerns that a potential demise of any of the existing Big audit firms in highly concentrated audit markets might de-stabilize the financial system There is also concern that “concentration among a few firms enabled the largest accounting firms to exercise greater influence over the audit standard setting process and regulatory requirements.” (GAO, 2003) Audit quality could also be compromised through moral hazard issues if large audit firms believe they are “too few to fail” (GAO, 2003) The lack of choice in audit markets dominated by Big audit firms is another concern Client firms might not want to be audited by the same audit firm that audits its competitors (European Commission (EU), 2011) Regardless of such comments, which reflect serious policy concerns about the consequences of heightened AMC, recent research often finds a positive relation between AMC and audit quality (Francis, Michas, & Seavey, 2013; Kallapur, Sandaraguruswamy, & Zang, 2010) In our paper we examine whether MPR can improve audit quality in low AMC jurisdictions where extant research tends to report lower audit quality than that in high AMC jurisdictions It might be noted that, to date, audit research has either examined the relation between audit quality and MPR without controlling for AMC (e.g Carey & Simnett, 2006; Chi et al., 2009) or the relation between AMC and audit quality without controlling for MPR (Kallapur et al., 2010) The unequal pace of audit market development across Chinese provinces makes it an ideal setting for our analysis For example, our Chinese MPR sample exhibits a wide range of variation in AMC at the provincial level During the 2004 to 2011 sample period, the provincial Herfindahl index based on audit fees and client locations varies between a minimum of 0.071 and a maximum of 0.982, with the first quartile of 0.125, a median of 0.155, and the third quartile of 0.217.5 We identify 273 unique Chinese publicly listed client companies countrywide that are subject to the MPR rule and compare their audit quality both pre- and post-MPR.6 We require our sample companies rotate out their signing audit partners when they have met the maximum five-year tenure requirement We also impose the condition that audit partner rotation not be accompanied by audit firm rotation in the periods before and after MPR to avoid a potentially confounding effect of audit firm rotation on audit quality Following prior research (e.g Chen et al., 2008; Francis et al., 2013), we use abnormal (discretionary) accruals as our measure of audit quality We find that on average MPR has a positive effect on audit quality in the post-rotation years, especially in the second and third years after MPR When we partition our sample by the provincial AMC levels, we find that the incremental benefit of MPR on audit quality is observed only in low, but not high, AMC provinces in China We then extend Firth, Rui, and Wu (2012a) to examine whether the interaction of the level of legal development with AMC has an effect on how MPR enhances audit quality Firth, Rui, and Wu (2012a) show that MPR has a positive effect on audit quality in China only in regions with low levels of legal development We find that the beneficial effect of MPR is observed in those provinces that not only have low levels of legal development but also low levels of AMC Our results are robust to alternative audit quality measures such as the discretionary working capital accruals (Carey & Simnett, 2006), different AMC measures, and various pre-MPR periods (one year before MPR and a three-year period before MPR), after controlling for audit firm tenure, client company size, cash flows, industry growth, age, state ownership, and leverage Our paper contributes to the literature by bringing together two different streams of extant audit research One stream examines the effects of MPR on audit quality, but the results are indeterminate The other stream of literature examines the effect of AMC on audit quality in papers such as Kallapur et al (2010) and Francis et al (2013) We contribute to the literature by investigating the effects of MPR on audit quality under different AMC conditions and different levels of legal development We show that MPR is able to enhance audit quality in Chinese provinces where both of these features are relatively underdeveloped However, Kallapur et al (2010) report US MSA (metropolitan statistical area) Herfindahl indexes of 0.230, 0.252, and 0.293 respectively for the first quartile, median, and the third quartile distributions in the 2000–2006 period However, these authors study the relation between AMC and audit quality but not in the MPR setting Relative to a cross-sectional comparison between MPR client firms and a control sample (e.g voluntary audit partner rotation or no-rotation sample, as in Chi et al., 2009) our pre- versus post-MPR comparison for MPR firms has the advantage of highlighting the consequence of MPR by eliminating the potentially confounding effects of covariates related to client firms' characteristics Please cite this article as: Bandyopadhyay, S.P., et al., Mandatory audit partner rotation, audit market concentration, and audit quality: Evidence from China, Advances in Accounting, incorporating Advances in International Accounting (2013), http://dx.doi.org/10.1016/j.adiac.2013.12.001 S.P Bandyopadhyay et al / Advances in Accounting, incorporating Advances in International Accounting xxx (2013) xxx–xxx the improvement in audit quality does not seem to be large enough to catch up with the high levels of audit quality enjoyed by client firms in provinces with high AMC and a high level of legal development Our findings suggest that the effect of MPR on audit quality needs to be examined on a case-by-case basis and cannot be subject to generalized conclusions for different audit market structures For example, the contradictory MPR results in Taiwan versus Australia might arise from not considering internal variations in audit market conditions in these countries Our results have some potential policy implications As previously mentioned, while regulators are concerned about the potential adverse effects of high AMC, audit quality is also demonstrated to be high in these jurisdictions Our study shows that MPR is a policy tool that could potentially improve audit quality in low AMC areas and thus avoid the attendant policy problems of high AMC However, given that our sample firms (273) constitute less than 20% of Chinese publicly listed companies, the generalizability of our results needs to be treated with caution The remainder of the paper is organized as follows In Section 2, we describe the institutional background and summarize the literature We develop our hypotheses in Section In Section 4, we discuss the sample selection procedure, variable measurement, and research methods Section summarizes our results Section concludes Institutional background and literature review Since the 1990s, Chinese accounting and auditing regulators, including the Chinese Institute of Certified Public Accountants (CICPA), the Ministry of Finance (MOF), and the China Securities Regulatory Commission (henceforth CSRC), have undertaken a number of steps to enhance audit independence In 1996, these national regulators required all Chinese audit firms that had previously had government affiliations to break off their government ties (Gul, Fung, & Jaggi, 2009) Regulators also adopted a new set of auditing standards in 1995, which ultimately resulted in their convergence with the International Standards on Auditing (ISA) promulgated by the IFAC (Firth et al., 2012a; Lin & Chan, 2000; Xiao, Zhang, & Xie, 2000) Moreover, in the wake of a series of accounting scandals that took place in the late 1990s and early 2000s, which resulted in the bankruptcy of Yinguangxia Company and other listed companies, the auditing license of the then largest audit firm in China, Zhongtianqin (Yinguangxia's auditors),7 was suspended The Chinese government then implemented a series of measures to restore public confidence in the financial reporting process (Chen, Sun, & Wu, 2010) In October 2003, the CSRC and MOF jointly issued a mandatory audit partner rotation rule (Chinese Securities Regulatory Commission (CSRC Regulation) & China Ministry of Finance (MOF), 2003 No 13) to improve audit independence and thus audit quality Under this rule, which became effective January 1, 2004, all Chinese-listed companies are required to rotate out their audit partners who have signed the company's audit reports for five consecutive years.8 As in Taiwan, Chinese audit reports have two signatories: a lead audit partner responsible for fieldwork Chen et al (2010), Appendix 1) provides a list of scandals in the Chinese stock market in the early 2000s Chen et al (2008) raise the concern that MPR may be superficial if a partner rotates back to the client after a very short “cooling-off” period They find that more than half of the partners in their Taiwanese sample, who rotated off in 2003 or 2004, rotated back after one year Note that there is no minimum cooling-off period for a rotation-off audit partner in Taiwan In contrast, Chinese regulations require a minimum two-year “cooling-off” period In our sample, 53 client companies are found to have re-appointed the same audit partners to their prior audit clients in Year 8, the year right after the required two-year cooling-off period We conduct sensitivity tests by eliminating these client companies and our results hold Firth, Rui, and Wu (2012b) findings are consistent with reduced audit quality associated with “rotated back” partners and a reviewing partner who must be at least a deputy executive of the audit firm.9 These two signing auditors are required to assume the same legal liability unless proved to the contrary (Firth et al., 2012a).10 To be consistent with prior literature, we refer to signing auditors as audit partners The usefulness of mandatory auditor rotation (at the firm or partner level) has been a matter of debate both in the financial press and in the academic auditing literature for a number of years Apart from a few jurisdictions, like Italy and Brazil, that have mandatory audit firm rotation, individual audit partner rotation has become a requirement in several jurisdictions including Australia (Carey & Simnett, 2006), Taiwan (Chi et al., 2009), China (Firth et al., 2012a), USA (SOX, 2002), Singapore, United Kingdom, France, Spain, Netherlands, Japan, and Germany (GAO, 2003, Appendix V) It is also currently being considered in Canada The adoption of MPR rules in these audit markets reflects regulators' concerns that lengthy audit partner tenure reduces audit quality on account of its adverse effect on audit independence Researchers have argued both in favor of and against mandatory rotation at the audit firm level.11 Some of these arguments apply to mandatory rotation at the audit partner level as well, because individual partners have incentives to maintain their relationships with a client in order to retain the client (Chen et al., 2008, page 420) The argument in favor of mandatory rotation is that a long association with an audit client clouds the auditor's judgment and leads to impairment of audit independence (Mautz & Sharaf, 1961) A new audit partner who rotates in to periodically replace an incumbent audit partner is expected to take a “fresh look” into different aspects of the engagement and improve audit quality Healey and Kim (2003) argue that mandatory rotation will restore “badly shaken investor confidence in the financial accounting system.” In an experimental study, Dopuch et al (2001) provide evidence that MPR increases auditor independence In another experimental study, Tan (1995, page 115) concludes that “staff rotation and review awareness can improve the quality of the audit decision process.” Raghunathan, Lewis, and Evans (1994) provide some evidence consistent with greater frequency of US Security Exchange Committee (SEC) actions against longer tenure audit firms, suggesting a potential beneficial role of MPR practice An important argument against mandatory rotation is that it will deprive the client of the firm-specific knowledge acquired by the incumbent auditor through a steep learning curve over a period of time (Knapp, 1991) This knowledge is not available to the replaced (rotated-in) auditor This view is largely supported in the extant US-based studies which, with few exceptions (e.g Davis, Soo, & Trompeter, 2009; Deis & Giroux, 1992) find that audit quality is poor in the early In the review process, a review partner examines audit plan, audit risk (inherent risk and control risk), audit evidence (e.g audit sampling), auditing adjustments, and audit report draft This is consistent with ISA regulations, under which engagement control review partners are required to review the risk of material misstatement (inherent risk and control risk) and audit sampling among others In our sample, we are unable to identify which of the two signing auditors is the lead or reviewing partner The authors' interviews with practitioners in China reveal that the order of two signatures is random for many auditing firms We find that our results are not sensitive to whether we center our MPR analyses on audit tenure of the first versus the second signing auditor In our sample, 108 of the 273 client companies of our sample rotated out their first signing audit partners, 83 rotated out the second signing audit partners, and 82 rotated out both partners 10 Chinese Independent Auditing Standards, adopted in 1995, are highly convergent with the ISA of the IFAC (Firth et al., 2012a; Lin & Chan, 2000; Xiao et al., 2000) According to the Chinese auditing standards, reviewing partners must hold the position of at least deputy executive in an audit firm In the review process, a review partner shall examine the audit plan, audit risk (inherent risk and control risk), audit evidence (from audit sampling), auditing adjustments, and audit report draft By ISA, the engagement control review partner shall also review the risk of material misstatement (inherent risk and control risk) and audit sampling among others The Chinese review audit partners' tasks, hence, share similarities with ISA's engagement quality control on audit review 11 In our paper, mandatory rotation refers to mandatory audit partner rotation, unless indicated otherwise Please cite this article as: Bandyopadhyay, S.P., et al., Mandatory audit partner rotation, audit market concentration, and audit quality: Evidence from China, Advances in Accounting, incorporating Advances in International Accounting (2013), http://dx.doi.org/10.1016/j.adiac.2013.12.001 S.P Bandyopadhyay et al / Advances in Accounting, incorporating Advances in International Accounting xxx (2013) xxx–xxx years of an audit firm's tenure with a specific client.12 This is consistent with the notion that audit quality improves as an audit partner acquires client-specific knowledge over time As a corollary, it could be argued that the loss of client-specific expertise when an incumbent audit partner is rotated out under MPR could hurt audit quality However, none of the foregoing US-based papers provide direct evidence on the consequences of MPR on measures of audit quality because they mostly study audit firm tenure but not individual audit partner tenure Direct empirical tests of the consequences of MPR on audit quality are mostly based on the audit and financial data obtained from Taiwan and Australia where13, unlike in the US, identities of the audit partners who perform the audit are disclosed In China, as in these countries, the names of the two audit partners engaged in auditing a client are public information Carey and Simnett (2006) examine the association between audit quality and long audit partner tenure using data from Australia for a period when audit partner rotation was not mandatory They find that audit quality declines with audit partner tenure when audit quality is measured as (1) the propensity to issue a going concern opinion for distressed firms, or (2) the probability of exceeding earnings benchmarks Also using Australian data, Hamilton, Ruddock, Stokes, and Taylor (2005) find less income-increasing discretionary accruals following MPR In contrast, using Taiwanese audit partner data, Chen et al (2008) find that audit quality increases with audit partner tenure and audit firm tenure, thus concluding that MPR (and also MFR) is likely to impair audit quality Similarly, Chi et al (2009) conclude that MPR does not help audit quality in Taiwan These authors find that the level of discretionary accruals of client companies in the year of MPR is no lower than the pre-rotation year level The above mentioned mixed results show that the effect of MPR on audit quality in Taiwan versus Australia is different, probably due to the specific audit market in which the relationship is examined In our study, we first examine the average effect of MPR on audit quality using Chinese audit data over all Chinese provinces This analysis provides fresh insights into the benefits or otherwise of MPR in a different audit market We then analyze how this relation changes with the provincial variation in AMC, which is an audit market characteristic not studied in previous Australian/Taiwanese research It is important to note that AMC has an independent effect on audit quality (e.g Francis et al., 2013; Kallapur et al., 2010) and might confound empirical tests of the relation between MPR and audit quality if its effect not controlled for Furthermore, international regulators are concerned about the adverse effects on audit quality of dominance of a handful of audit firms in international audit markets China exhibits wide variation in provincial AMC For example, the Herfindahl index based on audit fees and client locations is around 0.07 in the populous Guangdong province through our sample period, whereas the figure is around 0.55 for the equally populous Zhejiang province over the same period In the entire country, 64 audit firms audited 1570 listed clients in China (Chinese Institute of Certified 12 Gul, Jaggi, and Krishnan (2007) demonstrate greater earnings management in the early years of an audit firm's tenure Arel, Brody, and Pany (2005) show that audit failures are common in the initial years of an audit firm's audit engagement Geiger and Raghunandan (2002) measure audit failure as the inability of the auditor to issue a modified audit opinion before its client goes bankrupt and find more instances of audit failures in the early years of the audit firm's tenure Carcello and Nagy (2004) come to similar conclusions about the timing of financial statement frauds Stanley and DeZoort (2007) also find that audit failures tend to take place in the early years of an audit firm's tenure Several studies find a positive relation between financial reporting quality and audit firm tenure (e.g Johnson et al., 2002; Mansi, Maxwell, & Miller, 2004; Myers et al., 2003) This suggests that financial statement quality improves with audit firm tenure, which is in contrast to the non-linear relation between earnings management and audit firm tenure demonstrated by Davis et al (2009), who find that audit quality of firms with short (two to three years) or very long (13–15 years or more) tenure tends to be low Ghosh and Moon (2005) find a positive relation between earnings response coefficients and audit firm tenure 13 Recently, PCAOB has proposed that US audit firms disclose the name of the audit partner in charge of a client's audit (Rapoport, 2013) Public Accountants (CICPA), 2007 Bulletin No 15), averaging at less than 25 clients per audit firm The dominance of Big audit firms is much less evident in China (auditing 17% of all listed Chinese companies during 1999–2007 period) relative to many other jurisdictions (Francis et al., 2013) including the USA (61%), Australia (71%), and Taiwan (74%) Chinese regulators are wary of its audit markets being dominated by Big audit firms and is keen to encourage the growth of domestic firms to compete with large international audit firms that were allowed to operate directly in China after the country's accession to the World Trade Organization (henceforth WTO) in the post-2001 period (Chan & Wu, 2011).14 Variations in AMC across different Chinese provinces provide us with the opportunity to examine whether the beneficial effects of MPR on audit quality, if any, vary with AMC levels Finally, we examine if the relation between MPR and audit quality is affected by the level of legal development of the province in which the audit client is located, especially when viewed in conjunction with the AMC level of the province Chinese provinces not have a uniform level of legal development, and they exhibit large differences in this respect Fan, Wang, and Zhu (2004) measure the provincial level of legal development in terms of the number of lawyers as a percentage of the population, the efficiency of the local courts, and the protection of property rights Wang, Wong, and Xia (2008) show that there are great geographical disparities in legal development in China in terms of protection of property rights and efficiency of law courts among other legal elements Firth et al (2012a) examine the audit quality consequence of MPR in China in strong versus weak legal environments using the Wang et al (2008) criteria These authors find that client companies subject to MPR exhibit better audit quality than non-MPR companies in 2004, the first year that MPR was adopted in China However, this positive audit quality effect is restricted to client companies located in Chinese provinces suffering from low levels of legal development; the positive audit quality effect of MPR does not apply to more legally developed provinces However, Firth et al (2012a) not examine, as we do, the change in audit quality pre- and post-MPR for both the mandatory rotation year and up to two years subsequently More importantly, they not examine the audit quality effect of MPR conditional on varying provincial AMC levels In contrast, in our paper we examine how MPR affects audit quality for different provinces that exhibit different levels of legal development and AMC Hypotheses development As stated earlier, the effect of MPR on audit quality is the result of a tradeoff between having an independent and fresh look at the engagement by a new (rotated-in) audit partner versus losing the audit expertise of the departing (rotated-out) auditor Note that audit independence is defined in the literature as the joint probability that a given auditor will both (a) “discover a breach in the client's accounting system, and (b) report the breach” (DeAngelo, 1981) The rotated-in partner will probably have less hesitation in reporting a breach, if a breach is discovered, than the outgoing partner, because he or she would not have had enough time to build up a relationship with the client This is likely to enhance audit independence and thus audit quality However, the effects of MPR on the probability of discovering a breach is not very clear On the one hand, the new partner, by taking a “fresh look” (Mautz & Sharaf, 1961), might find it easier to uncover a 14 The motivation for Chinese regulators to encourage the growth of domestic audit firms is to improve the supply of quality audit services to meet the increased demand resulting from the transformation of state-owned enterprises (SOE) into public-listed companies (Chan & Wu, 2011) Note that before SOEs were privatized, they were audited by the National Audit Office of the People's Republic of China, not independent audit firms In addition, the demand for large domestic audit firms arose from sovereignty considerations, rather than audit market considerations, especially after the Chinese accession to WTO In other words, the Chinese government felt it was more desirable to have large local audit firms dominate the Chinese audit market than large foreign Big audit firms Please cite this article as: Bandyopadhyay, S.P., et al., Mandatory audit partner rotation, audit market concentration, and audit quality: Evidence from China, Advances in Accounting, incorporating Advances in International Accounting (2013), http://dx.doi.org/10.1016/j.adiac.2013.12.001 S.P Bandyopadhyay et al / Advances in Accounting, incorporating Advances in International Accounting xxx (2013) xxx–xxx breach, compared to the outgoing partner On the other hand, the new partner probably will not possess the firm-specific expertise enjoyed by the outgoing partner, thereby making it harder for him or her to detect a breach, if one exists The outcome of the tradeoff of the “fresh look” versus reduction of client-specific expertise on the probability of discovering a breach is an empirical issue.15 Thus, because it is determined by the joint probability of discovering a breach and disclosing a breach, overall improvement of audit quality due to MPR is hard to predict Extant evidence on the effect of MPR on audit quality, which relies on empirical research using Australian (Carey & Simnett, 2006; Hamilton et al., 2005) and Taiwanese (Chen et al., 2008; Chi et al., 2009) audit data, is mixed Experimental studies, on the other hand, show positive effects of MPR on audit independence (Dopuch et al., 2001) and audit quality (Tan, 1995) Given the theoretical and empirical evidence, our first hypothesis about average audit quality in Chinese audit markets across all provinces is non-directional H1 Average audit quality across Chinese provinces does not change after mandatory audit partner rotation as compared to the prerotation period As stated earlier, AMC varies greatly across different provinces in China In this paper we also examine the effect of MPR on audit quality under varying AMC conditions at the provincial level To the best of our knowledge, there has not been any theoretical analysis of this issue However, the literature does provide a number of conflicting predictions about the potential effects of AMC on audit quality For example, in a theoretical paper, Chaney, Jeter, and Shaw (2003) argue that the cost of losing a single client when an auditor tells the truth about a breach is quite small under high competition (low AMC) because of the low profit margins in these markets and a large client pool These authors state that the low cost of “telling the truth” would encourage disclosure of a breach and improve audit quality in high competition audit markets It is unclear, however, how MPR will change this cost of telling the truth in highly competitive (low AMC) audit markets In contrast, DeAngelo (1981) argues that large audit firms with a large client base have strong incentives to remain independent because of large quasi rents they earn from their clients Large quasi rents exist because the potential reputation cost arising from an audit failure is likely to be high for large audit firms This implies that audit markets that are dominated by a small number of large audit firms (or high AMC) will exhibit a high level of audit independence and therefore high audit quality If this argument is true, MPR will likely not affect audit quality in high AMC markets incrementally either, given that audit quality is probably high to begin with.16 In addition, Watts and Zimmerman (1981) argue that larger audit firms, which dominate concentrated audit markets, are better at monitoring their auditors in comparison with small audit firms Since the cost of audit failure is high for large audit firms, resulting in costly decline in reputation and probable shareholder lawsuits, these audit firms monitor their audit partners very closely Therefore, the incremental effect of MPR, with its fresh look into the engagement by a rotated-in partner, is likely to be minimal This implies that any enhancement to audit quality from MPR is more likely to be significant in less concentrated (highly competitive) audit markets where audit firm, on average, are likely to be smaller, and the level of monitoring of audit partners by the audit firm is probably less intense The forgoing discussions indicate that the predicted effects of MPR on audit quality under differing AMC conditions are uncertain Empirical 15 In any case, we control for audit expertise effects by including incoming partner's industry experience in our empirical tests 16 “Theory suggests that auditor independence and audit quality are inextricably linked, with auditor independence being an integral component of audit quality.” (GAO, 2003) evidence tends to show that audit quality is better in high AMC US city markets (Kallapur et al., 2010) and international country-level markets (Francis et al., 2013) Despite this, some influential commentators hold a different view For example, Honorable Richard Breeden (see PCAOB, 2012, page 5), an ex-chairman of the SEC, has stated that the present value of future revenues from a few large audit engagements of any Big N audit firm, assuming “continued incumbency,” could exceed several billion dollars, which “helps to explain why the issue of auditors trying to please the largest clients continues to arise.” This view is consistent with audit quality being low in highly concentrated markets, where MPR might have a beneficial effect Since the relation between MPR and audit quality under different audit market conditions is ambiguous, our second hypothesis, also non-directional, is as follows: H2 The improvement in audit quality after mandatory audit partner rotation in provinces with low audit market concentration is not different from that in provinces with high audit market concentration Finally, we examine the effect of market concentration in interaction with legal development on the change in post-MPR audit quality As stated earlier, Firth et al (2012a) find that the level of legal development in Chinese provinces affects the relation between MPR and audit quality using the provincial legal environment index of Wang et al (2008).17 Arguably, market discipline and more effective monitoring in the high AMC and high legal development provinces allow audit firms to maintain a high level of audit quality regardless of MPR The code of auditor ethics and legal environment likely provide an effective monitoring mechanism for maintaining audit independence in jurisdictions with high levels of AMC and a strong legal enforcement framework Thus, incremental benefits from MPR, if any, might be less significant in provinces with high AMC and a strong legal environment relative to provinces of low AMC and low legal development However, we not have a directional hypothesis on this interaction effect because it is also possible that audit quality in low AMC and low legal development provinces does not improve after MPR due to potentially weak market discipline and government regulation Our third hypothesis also has no directional predictions: H3 The improvement in audit quality after MPR in provinces with low audit market concentration and low legal development is not different from that in provinces with high audit market concentration and high legal development Sample selection and research design 4.1 Sample selection We obtain our audit and financial data from a database compiled by Sinofin Technology Limited Co and China Center for Economic Research (CCER) of Beijing University The names of the signing auditors and audit firm data of Chinese publicly listed companies are available in the CCER database starting from 2000 We manually collect 1999 audit data from publicly available CICPA archives to compile data over a five-year period from 1999 to 2003, as illustrated in Appendix 1, for identifying clients firms' MPR in 2004, the first year of adoption of the MPR rule.18 Our sample covers the 1999–2011 period We require signing auditors' identity data for consecutive six-year rolling windows starting from 1999 in order to identify mandatory audit partner changes starting in 2004, the first year of MPR Any effect of MPR on audit quality 17 We provide details on the legal environment index measure in Section Our sample does not include those companies that adopted the MPR rule early in 2003 All Chinese-listed companies are required to have a fiscal year end of December 31 18 Please cite this article as: Bandyopadhyay, S.P., et al., Mandatory audit partner rotation, audit market concentration, and audit quality: Evidence from China, Advances in Accounting, incorporating Advances in International Accounting (2013), http://dx.doi.org/10.1016/j.adiac.2013.12.001 S.P Bandyopadhyay et al / Advances in Accounting, incorporating Advances in International Accounting xxx (2013) xxx–xxx could take longer than one year because rotated-in audit partners might require some time to familiarize themselves with the new client's business Therefore, we compare client firms' audit quality in the pre-MPR period versus the MPR year, and two subsequent years as well, in order to examine longer-term effects of MPR, if any Our last MPR year is 2009 because 2011 is the last year of our sample period Appendix describes the method we follow to classify an audit partner change as mandatory rotation We refer to the first year that we start counting audit partner tenure as Year 1, the last year prior to MPR as Year 5, the MPR year with new rotated-in audit partner as Year 6, and the two subsequent years as Years and 8, respectively We classify an audit partner change as a mandatory rotation if the previous incumbent audit partner “A” had audited a client from Years to but was replaced by audit partner “B” in Year In our main tests, we compare audit quality of Year versus Years 6, 7, and For example, for client companies subject to MPR in 2004 (Year 6), we use 2003 data to evaluate Year audit quality, and 2006 and 2007 data to evaluate Years and 8, respectively As shown in Table 1, we begin with the CCER sample of 13,287 firm–year observations for the 2004–2011 period After eliminating observations with missing audit partner names in Year and the five preceding years, we obtain 7094 firm–year observations, representing an average of 887 client companies per year Out of this sample, we select 455 unique client companies who rotate their audit partners after they finish their five-year tenure for the first time during 2004–2009 We remove another 169 client Table Sample selection and composition Panel A: Sample selection China Center for Economic Research (CCER) Database Total number of firm–year observations during 2004–2011 Less: Number of firm–year observations that had missing signing audit partners' names in the current year (2004–2011) and the five preceding years (1999 audit partner and audit firm data were hand-collected) Preliminary sample: Number of firm–year observations (2004–2011) Average number of client firms per year Mandatory partner rotation sample selection: Number of companies that had auditor rotations after a five-year tenure for the first time at Year (2004–2009) Less: Number of companies with audit firm change in Year or the five preceding years Less: Number of companies that should rotate both partners but only rotate one after mandated tenure (one-year extension allowed when both audit partners' tenure reached five years in the same year) Less: Number of companies that have missing abnormal accruals in Year and Year Remaining number of companies: Number of firm–year observations in the period 2004–2011 (279 times years, namely, Year 5, Year 6, Year 7, and Year 8) Less: Observations with audit firm change in Years or Less: Observations with missing abnormal accrual values in Years or Less: Observations with missing values in control variables Remaining number of firm–year observations (273 for Year 5, 273 for Year 6, 197 for Year 7, and 144 for Year 8): No of Obs 13,287 (6193) 7094 887 455 companies that change audit firms during the Year to Year period.19 We then exclude companies which rotated only one audit partner when both partners should have been replaced after the mandated maximum five-year tenure, as well as companies with missing accrual data during Years 5–6 We are left with 273 remaining unique client companies (or 1092 firm–year observations) after completing these data screening procedures As described above, our sample selection procedure requires client companies to have the same audit firms in the five-year period (Years to 5) preceding the identified mandatory rotation year (Year 6) In addition, in the two-year period subsequent to the MPR year, if there is an audit firm change in Year 7, we eliminate the corresponding Year and Year observations Alternatively, if there is no audit firm change in Year but there is one change in Year 8, we keep the Year observation and eliminate only the Year observation In this way, we attempt to remove any confounding effect of audit firm change in our empirical analyses; we also try to restrict loss of power of tests arising from small sample size by not requiring the inclusion of all three post-MPR years (Years 6, 7, and 8) in the sample selection procedure.20 Our final sample has 887 firm–year observations, including 273 respectively for each of Year and Year 6, 197 for Year 7, and 144 for Year (see Panel B of Table 1) Note that we identify Year as the first year of a client company's first-time mandatory audit partner rotation after the adoption of the MPR rule As in Australia and Taiwan, Chinese audit reports have two signing audit partners, namely, a lead engagement partner and a reviewing partner The rule allows a one-year postponement for one of the two signing auditors if both signing auditors reach their fiveyear tenure at the same time (Chinese Securities Regulatory Commission (CSRC Regulation) & China Ministry of Finance (MOF), 2003 No 13) For example, consider a client with two signing audit partners, one of them having audited the client for five years, but the other for only four years According to the mandatory rotation rule, the first auditor is required to rotate out in Year 6, but the second auditor is allowed to audit the client for one more year Therefore, for this case, the second mandatory rotation happens in Year We identify the first year of the client firm's MPR as Year 6; we treat the second MPR year as Year It is also possible that audit partner changes in Years and that take place before the expiry of the MPR imposed maximum five-year tenure are voluntary In order to address any confounding effects arising from multiple audit partner rotations in post-MPR years, we eliminate those observations that are associated with audit partner changes (71 voluntary and 47 mandatory) in Years and in our sensitivity checks Our results hold (169) (7) (6) 273 1092 (202) (2) (1) 887 4.2 Audit quality measures Following the literature, we use an earnings quality measure, namely, discretionary (abnormal) accruals, as a proxy of audit quality Prior research shows a positive relation between measures of high quality audit (such as audit firm size or industry expertise) and high quality financial reporting (Balsam, Krishnan, & Yang, 2003; Ghosh & Moon, 2005; Johnson, Khurana, & Reynolds, 2002; Krishnan, 2003; Myers, Myers, & Omer, 2003) The underlying argument is that high quality auditors are capable of detecting questionable accounting practices and misrepresentations as reflected in discretionary accruals If managers are unwilling to address the auditor's concerns about their discretion in financial reporting, high quality auditors are more likely than other Panel B: Distribution of mandatory rotation years: 2004 2005 2006 2007 2008 2009 Total 54 72 63 39 33 12 273 19 We eliminate client companies with audit firm changes to isolate the effect of mandatory audit partner rotation Companies can change their audit firms for many reasons For example, Johnson and Lys (1990) show that audit firm changes are related to client characteristics and audit firm cost structures Schwartz and Menon (1985) report that client firms with poor performance may switch their audit firms on account of disputes regarding audit opinions, reporting issues, management changes, and audit fees 20 We thank our anonymous reviewer for this suggestion Please cite this article as: Bandyopadhyay, S.P., et al., Mandatory audit partner rotation, audit market concentration, and audit quality: Evidence from China, Advances in Accounting, incorporating Advances in International Accounting (2013), http://dx.doi.org/10.1016/j.adiac.2013.12.001 S.P Bandyopadhyay et al / Advances in Accounting, incorporating Advances in International Accounting xxx (2013) xxx–xxx auditors to issue qualified audit reports (see DeAngelo, 1981) Myers et al (2003), page 783) argue that “high quality audits mitigate more extreme management reporting decisions, and suggest that accruals can be used to identify these extreme reporting decisions.” Empirical studies with Chinese data provide evidence that discretionary accruals measures are capable of capturing earnings manipulation behavior in China (Ting, Yen, & Huang, 2009; Yu, Du, & Sun, 2006) Consistent with prior research on MPR and audit quality (Chen et al., 2008; Chi et al., 2009), we measure discretionary accruals using the modified Jones model (Dechow, Sloan, & Sweeney, 1995) matched by performance (Kothari, Leone, & Wasley, 2005) For simplicity, firm subscript is omitted in Eq (1) and later equations TotalAccuralst =Assetst1 ẳ ỵ 1=Assetst1 ị þ β1 ðΔSt−ΔARt Þ=Assetst−1 β2 ðPPEt−1 =Assetst−1 Þ þ β3 ROAt1 ỵ t 1ị where total accruals (TotalAccruals) equal net income before extraordinary items minus operating cash flows, ΔS is change in sales, ΔAR is change in account receivables, PPE is net property, plant and equipment, ROA is return on assets, and t is the year subscript All variables are scaled by lagged assets (Assetst − 1) We estimate Eq (1) using the full CCER sample with non-missing values of the regression variables by industry–year We require at least 15 valid observations for each industry–year regression The industry category follows the 13-industry codes announced by CSRC The mean coefficients of industry–year regressions are used to estimate the fitted values of non-discretionary accruals Discretionary accrual (DA) is computed as the total accruals minus the fitted values Following Carey and Simnett (2006), we also use discretionary working capital accruals (DWCA) in our sensitivity test Extant literature uses a number of different measures of audit quality, for example, absolute values (unsigned) of discretionary accruals, signed values, or positive/negative values of discretionary accruals In this paper, we focus on the signed value of discretionary accruals for two reasons The first reason follows from the results of Hribar and Nichols (2007) indicating that firm characteristics such as operating volatility are related to the error variance in discretionary accruals These authors argue that this correlation could weaken the statistical power of detecting low quality earnings using the unsigned (or absolute values of) discretionary accruals measure Besides Hribar and Nichols (2007), Carey and Simnett (2006) and Francis et al (2013) also focus on the signed discretionary accruals in their analysis of audit quality The second reason is regulatory; Chinese-listed companies have disincentives to recognizing extreme incomedecreasing accruals arising from CSRC-imposed regulations for eligibility for rights offerings The most rigid regulation is the minimum ROE requirement.21 This regulation is widely applicable because almost all listed firms tend to seek permission to undertake rights offerings (Chen & Yuan, 2004) 21 The requirement for rights offerings was changed a number of times, reflecting the CSRC's efforts to protect shareholders against management expropriation For example, rights offerings required two consecutive years of profits after December 1993, and a three-year average ROE not below 10% after September 1994 The rules changed in January 1996, which required that for each of previous three years prior to a rights offering, the incumbent firms' three-year average ROE must not fall below 10% This rule was changed again in March 1999, which required the maintenance of a minimum ROE level of not below 6% for each of previous three years before rights offerings After May 2006, these firms needed to maintain a minimum three-year weighted average ROE of 6% For regulations on rights offerings, see the CSRC's regulation released on May 8, 2006, available on the official webpage http://www.csrc.gov.cn 4.3 Research models We estimate the following equation to compare the audit quality of Year 5, the last year prior to MPR, versus the three post-mandatory rotation Years: 6, 7, and DA ẳ ỵ POST ỵ IBIG4 ỵ CIBIG10 ỵ FT ỵ SIZE ỵ CFO ỵ6 GROW ỵ AGE ỵ SOE ỵ LEV ỵ 10 TTYPE ỵ 11 EXP ỵ12 CLIENTP ỵ Year ỵ Industry ỵ 2ị where DA is discretionary accruals POST is an indicator variable that equals one for Years 6, 7, and and zero for Year The constant term (α0) represents audit quality of Year 5, after controlling for covariates A negative coefficient (α1) on the POST variable is consistent with audit quality improvement in the post-rotation period relative to the benchmark last pre-rotation year (Year 5), after controlling for covariates A positive coefficient of POST indicates lower audit quality after MPR Following prior research (Carey & Simnett, 2006; Chen et al., 2008; Chi et al., 2009; DeFond, Raghunandan, & Subramanyam, 2002), we include several control variables in Eq (2) Audit firm size variables IBIG4 and CBIG10 equal one respectively for Big international audit firms and Top 10 Chinese audit firms22 and zero otherwise FT is audit firm tenure measured as the number of years that a client firm is audited by the same audit firm.23 SIZE is client company size computed as the natural logarithm of total assets Audit firm size and audit firm tenure control for the audit quality effects of audits by large audit firms and by audit firms with a long tenure with its incumbent client We include cash flow variable CFO (operating cash flows scaled by lagged assets) because prior research shows that it is negatively associated with accruals (Chi et al., 2009) GROW is growth in sales, measured as the total sales of the current year scaled by the industry total sales of the last year AGE is the number of years that the client firm is listed in a Chinese stock exchange, which controls for the propensity of relatively younger companies in high-growth industries to recognize extreme accruals In addition, we include the SOE variable, which equals one, for stateowned enterprises, and zero otherwise Chen, Chen, Lobo, and Wang (2011) argue that SOE companies have less incentive to manage earnings relative to non-SOE companies because the differences in the nature of the ownership, agency relations, and bankruptcy risks However, we not predict the sign of the SOE variable Aharony, Lee, and Wong (2000) argue that while SOE managers not have the same incentives as US managers to manage earnings since they not own any shares of the firm, they might still earn high prestige and other non-pecuniary benefits from reporting higher earnings by undertaking earnings management activities We also include a leverage variable (LEV) to capture the effects of risk associated with high levels of debt (Carey & Simnett, 2006) LEV equals total liability scaled by total assets TTYPE is an indicator variable for special treatment stocks to capture earnings incentives arising from potential delisting risks.24 We 22 The top 10 Chinese audit firms are selected based on the ranking prepared by CICPA in 2009 Chen, Chen, Lobo, and Wang (2011) use Top to categorize big audit firms in their study 23 Audit data in CCER become available in 2000 Therefore, we count the number of years that an audit firm serves a client (audit firm tenure) starting in 2000 For observations with MPR year in 2004, we manually check 1999 audit firm data to ensure that audit firms are the same in 1999 24 ST/PT/ ∗ ST firms are firms that report consecutive losses and face substantial delisting risk According to the rules introduced by the CSRC in 1999, a firm is designated as a special treatment (ST) firm if it incurs losses for two consecutive years and a particular treatment (PT) firm if it continues to report a loss for another year A PT firm is delisted if it fails to become profitable in the following year PT stocks cannot be traded except on Fridays and are limited to a maximum 5% price increase over the last Friday's close (no downside limit) The PT designation has been discontinued by the CSRC in 2002 Since 2003, the CSRC introduced a new designation called “*ST”, which is similar to ST, to further advise the market of the risk that a company will be delisted if its loss continues the following year If a firm incurs losses for three consecutive years, it is de-listed Please cite this article as: Bandyopadhyay, S.P., et al., Mandatory audit partner rotation, audit market concentration, and audit quality: Evidence from China, Advances in Accounting, incorporating Advances in International Accounting (2013), http://dx.doi.org/10.1016/j.adiac.2013.12.001 S.P Bandyopadhyay et al / Advances in Accounting, incorporating Advances in International Accounting xxx (2013) xxx–xxx Table Variable distributions and correlation matrix Panel A: variable distributions Variable Mean Std dev Min 25% Median 75% Max DA DWCA IBIG4 CBIG10 HERF LEGAL FT SIZE CFO GROW AGE SOE LEV TTYPE EXP CLIENTP 0.001 −0.140 0.054 0.157 0.202 5.951 6.515 21.515 0.059 1.266 9.079 0.661 0.540 0.159 0.020 0.045 0.091 5.594 0.226 0.364 0.152 1.230 1.387 0.990 0.099 0.205 3.036 0.474 0.366 0.366 0.037 0.066 −0.387 −0.584 0 0.071 2.620 17.967 −0.645 0.787 0 0.021 0 −0.043 −0.063 0 0.125 5.050 20.831 0.014 1.161 0.389 0.002 0.009 0.006 0.004 0 0.155 5.630 21.472 0.054 1.212 0.544 0.006 0.022 0.042 0.075 0 0.217 6.980 22.147 0.105 1.357 11 0.657 0.018 0.056 0.706 0.679 1 0.982 7.970 25.585 0.601 3.284 18 7.788 0.297 0.598 Panel B: Pearson correlation matrix Variable DA DWCA HERF LEGAL FT SIZE CFO GROW AGE LEV EXP DWCA HERF LEGAL FT SIZE CFO GROW AGE LEV EXP CLIENTP 0.164 −0.010 −0.065 −0.041 0.087 −0.639 −0.007 −0.027 −0.160 −0.002 0.021 0.014 0.020 0.020 −0.011 −0.017 0.021 0.013 −0.097 0.007 0.059 0.194 0.129 0.053 −0.042 −0.004 −0.007 0.049 0.121 −0.120 0.026 0.175 −0.073 0.015 0.171 −0.053 0.134 −0.105 0.197 0.020 −0.071 0.397 0.043 −0.103 −0.156 0.096 0.081 −0.003 −0.032 0.000 −0.008 −0.008 0.003 −0.076 −0.045 0.049 −0.033 −0.066 −0.085 −0.034 0.082 −0.071 −0.067 0.145 0.026 −0.033 See Appendix for variable definitions Bold numbers in Panel B are correlations significant with p b 0.05 (including b0.01) EXP (CLIENTP) variable values in Panel B are the residuals from the first-stage regression EXP (CLIENTP) on SIZE (see Section 4.3 for the details of the two-stage method) not have predictions for LEV and TTYPE While financially distressed firms with high debt and delisting risk may be aggressive in accruals recognition, these firms may have to reduce instances of earnings management because of potentially restrictive debt covenants for high leverage firms and/or the tight levels of regulations on TTYPE companies The EXP variable measures the two incumbent audit partners' combined experience in auditing clients in the incumbent client's industry An audit partner's industry experience is measured as the percentage of his/her audited client companies' assets in the same industry Note that the EXP score associated with the rotated-in partner(s) compensates partially for the audit expertise that is lost with the departing partner(s) As mentioned earlier, the effects of MPR on audit quality reflect a tradeoff of enhanced audit independence versus loss of client-specific audit expertise After controlling for EXP (and effects of covariates), the indicator variable POST captures the change in post-MPR audit quality arising from potentially improved audit independence The CLIENTP variable measures client power, which equals the percentage of a client's total assets as a percentage of its audit firm's total audited assets countrywide This variable and EXP are both highly correlated with the SIZE variable, with correlation coefficients of around 0.50 (un-tabulated) In an attempt to reduce the potential effects of multicollinearity, we use a two-stage approach We first run two regressions, namely EXP on SIZE, and CLIENTP on SIZE We derive the residuals of each regression by taking the actual EXP (CLIENTP) value minus its fitted value Then we use the residual values, which are orthogonal to SIZE values, to estimate Eq (2) We control for Industry (Industry) and year (Year) fixed effects in all regressions Appendix provides details on the measurement of all variables To assess the effect of MPR on audit quality in each of the individual post-MPR years, we revise Eq (2) by replacing the POST variable with three indicator variables Y6, Y7, and Y8, that equals one, respectively, for Years 6, 7, and 8, and zero for pre-rotation period (Year 5) DA ẳ ỵ Y6 ỵ Y7 ỵ Y8 ỵ IBIG4 ỵ CBIG10 ỵ FT þβ4 SIZE þ β5 CFO þ β6 GROW þ β7 AGE ỵ SOE ỵ LEV 3ị ỵ10 TTYPE þ β11 EXP þ β12 CLIENT þ δ YEAR þ Industry ỵ Data descriptive statistics and research ndings 5.1 Data descriptive statistics Table Panel A reports the descriptive statistics of the selected sample The means of different indicator variables show that 5.4% of the sample observations are audited by Big international audit firms (IBIG4), and 15.7% by the Top 10 largest Chinese audit firms (CBIG10); 66.1% reflect state ownership (SOE) of client firms; and finally, 15.9% were listed as special treatment stocks or particular transfer stocks (TTYPE) at some point by the CSRC in Year and/or Year The average firm tenure (FT) is approximately 6.5 years The average leverage ratio (LEV) is 54.0%, with a median of 54.4% The minimum and maximum values of discretionary accruals (DA), discretionary working capital accruals (DWCA), and other variables not exhibit obvious outliers.25 Table Panel B reports the Pearson correlation matrix of our variables 25 To address the effects of potentially influential observations, we winsorize variable values at the levels of 1% and 99% We also use r-student screening (Belsley, Kuh, & Welsch, 1980) in all our regressions by eliminating observations with r-student absolute values greater than in the regressions Please cite this article as: Bandyopadhyay, S.P., et al., Mandatory audit partner rotation, audit market concentration, and audit quality: Evidence from China, Advances in Accounting, incorporating Advances in International Accounting (2013), http://dx.doi.org/10.1016/j.adiac.2013.12.001 S.P Bandyopadhyay et al / Advances in Accounting, incorporating Advances in International Accounting xxx (2013) xxx–xxx Table Audit Quality Pre versus Post-MPR Pred sign DA (DA N 0) DA DA (DA b 0) DA Coef POST Y6 Y7 Y8 IBIG4 CBIG10 FT SIZE CFO GROW AGE SOE LEV TTYPE EXP CLIENTP Constant Obs no Adj R2 (%) +/− +/− +/− +/− − − − + − + − +/− ? ? − + ? (t-value) Coef (t-stat) Coef (t-stat) −0.012*** (−2.54) −0.059** (−1.97) −0.001 (−0.12) −0.016* −0.006 −0.001 0.014*** −0.637*** 0.001 0.001 0.009*** −0.080*** 0.014** −0.035 0.063 −0.240*** 879 54.01 (−1.77) (−1.04) (−0.20) (5.80) (−18.85) (0.06) (1.52) (2.15) (−6.09) (2.04) (−0.44) (1.56) (−4.24) −0.093** −0.041 0.007 0.039*** −0.898*** −0.114 0.005 0.041* −0.384*** 0.041 0.102 −0.091 −0.435 479 39.87 (−2.37) (−1.43) (0.53) (2.98) (−6.96) (−1.33) (1.12) (1.78) (−5.24) (1.35) (0.28) (−0.41) (−1.48) 0.001 −0.001 −0.001 0.002 −0.582*** 0.029 0.001 0.000 −0.015 0.030*** −0.151 0.109 −0.033 408 46.87 (0.08) (−0.06) (−0.20) (0.34) (−13.22) (0.83) (0.37) (−0.03) (−0.73) (2.62) (−0.92) (1.58) (−0.31) Coef (t-stat) −0.008 −0.014*** −0.017*** −0.016* −0.006 −0.001 0.014*** −0.607*** −0.005 0.011* 0.008* −0.080*** 0.014** −0.073 0.058 −0.237*** 881 53.29 (−0.99) (−2.66) (−2.63) (−1.78) (−0.99) (−0.31) (5.52) (−18.05) (−0.26) (1.64) (1.75) (−6.00) (1.97) (−0.89) (1.42) (−3.99) See Appendix for variable definitions All regressions control for industry and year fixed effects Truncated regressions were used in the positive and negative abnormal accrual regressions *, **, *** significant respectively at 10%, 5%, and 1% levels with two-tailed tests DA and DWCA are positively correlated DA is negatively correlated with HERF, LEGAL, CFO, and LEV 5.2 Results of H1 Table reports the regression results of estimating Eqs and Note that all our tests are two-tailed t-tests because our hypotheses are nondirectional Standard errors are clustered at individual client firm level since discretionary accruals are firm-specific.26 Using signed discretionary accruals (DA) as the dependent variable in Eq (2), we find that the indicator variable, POST, has a negative coefficient of −0.012 (t-stat = −2.54) significant at less than 5% level This result is consistent with the notion that audit quality in the post-MPR years is superior to that in the last year prior to the start of MPR We also estimate truncated regressions respectively for positive DA and negative DA observations We find that a positive DA subsample has less income-increasing abnormal accruals in the POST period (α3 = −0.059, t-stat = −1.97, p b 10), but a negative DA subsample exhibits no significant change in audit quality in the post-MPR period This is consistent with sample firms not undertaking “big baths” (potential reasons for firms recognizing negative accruals) in the post-MPR period For Eq 3, while the coefficient on the first rotation year (Y6) is insignificant, both Year (Y7) and Year (Y8) coefficients are negative and significant (α2 = −0.014, t-stat = −2.66; α3 = −0.017, t-stat = −2.63) at less than the 1% level Collectively, these results indicate that client companies report less extreme income-increasing abnormal accruals after MPR.27 The control variables in Table are generally consistent with our predictions Specifically, our findings of positive coefficients on SIZE and negative coefficient on CFO are consistent with Chi et al (2009) 26 We use the SAS programming codes provided by Noah Stoffman, Kelley School of Business, Indiana University (http://kelley.iu.edu/nstoffma/fe.html) to run regressions with clustered standard errors and fixed effects models While the degree of freedom is much less after controlling for (client) firm effects in the fixed effects model, our results (un-tabulated) hold 27 The truncated regressions not report the adjusted R-Squared When using OLS regressions, the adjusted R-Squared is respectively 39.87% and 46.87% for the incomeincreasing and income-decreasing accrual regressions and Francis et al (2013) Our positive coefficient on SOE is consistent with SOE companies having incentives to use income-increasing accruals to boost bottom line net incomes (Aharony et al., 2000) We find some evidence of high audit quality associated with Big international firms' audits We also find that high leverage clients report more income-decreasing accruals and that there is some evidence that TTYPE clients are more aggressive in recognizing income-increasing accruals 5.3 Results of H2 and H3 Hypothesis H2 examines whether the MPR's effect on audit quality in provinces with less concentrated audit markets is different from that in other provinces To test H2, we compute the Herfindahl index for each client-province as the sum of squared audit firm fee shares of all audit firms in a province We estimate Eq for two subsamples grouped by the observations that reflect clients located in provinces with higher than the median provincial Herfindahl index versus those with lower than the median provincial Herfindahl index.28 Table summarizes the regression estimates of Eq (2) for clients located in provinces that exhibit Herfindahl indices less than the median level (low AMC) versus more than the median level (high AMC) The results show that the POST variable is insignificant for the high AMC group but significant at less than the 5% level for the low AMC group using two-tailed tests (coefficient = − 0.017, t-stat = − 2.30) The control variables have similar coefficients across the two regressions SIZE and LEV are both significant at less than 1% level We also examine the stand-alone effect of legal environment on the relation between MPR and audit quality (Firth et al., 2012a) The provincial legal environment index scores are taken from Wang et al (2008), Table A1) These authors report the levels of legal development index 28 We also estimate Eq (3) using the same sample decompositions by median of the median of provincial Herfindahl index, and the median of legal development index Consistent with Eq (2) results reported in Table 4, our results (un-tabulated) suggest audit quality improvement in the post-MPR period, especially in Years and 8, for the low Herfindahl index and low legal development index groups, respectively Please cite this article as: Bandyopadhyay, S.P., et al., Mandatory audit partner rotation, audit market concentration, and audit quality: Evidence from China, Advances in Accounting, incorporating Advances in International Accounting (2013), http://dx.doi.org/10.1016/j.adiac.2013.12.001 10 S.P Bandyopadhyay et al / Advances in Accounting, incorporating Advances in International Accounting xxx (2013) xxx–xxx Table Audit quality pre versus post-MPR: conditioning on AMC or legal environment Pred DA DA DA DA Sign Low AMC High AMC Low Legal High Legal Coef POST IBIG4 CBIG10 FT SIZE CFO GROW AGE SOE LEV TTYPE EXP CLIENTP Constant Obs no Adj R2 (%) +/− − − − + − + − +/− ? ? − + ? (t-value) Coef (t-stat) Coef (t-stat) Coef (t-stat) −0.017** −0.040** −0.017 0.002 0.014*** −0.584*** −0.042 0.001 0.013** −0.080*** 0.025*** −0.117 0.160*** −0.214*** 448 49.05 (−2.30) (−2.23) (−1.23) (0.47) (4.17) (−9.75) (−1.24) (0.98) (2.14) (−4.34) (2.60) (−1.12) (2.99) (−2.65) −0.009 0.004 0.002 −0.002 0.013*** −0.652*** 0.055** 0.001 0.005 −0.080*** 0.003 −0.005 0.005 −0.265*** 433 59.73 (−1.46) (0.46) (0.38) (−0.66) (3.61) (−18.83) (2.06) (0.83) (0.78) (−4.06) (0.37) (−0.04) (0.08) (−3.25) −0.017*** −0.019 −0.008 0.002 0.015*** −0.600*** 0.024 0.001 0.012* −0.098*** 0.013 −0.044 −0.001 −0.273*** 454 45.22 (−2.47) (−1.49) (−0.87) (0.53) (4.46) (−13.33) (0.69) (0.85) (1.83) (−4.97) (1.31) (−0.27) (−0.02) (−3.26) −0.002 −0.021 −0.003 −0.007* 0.014*** −0.730*** −0.012 0.001 0.003 −0.074*** 0.028** 0.112 0.169*** −0.223*** 426 67.03 (−0.25) (−1.50) (−0.36) (−1.69) (3.92) (−12.93) (−0.45) (1.50) (0.49) (−4.21) (2.37) (1.06) (2.81) (−2.69) See Appendix for variable definitions Low and high AMC regressions are respectively for the two subsamples of below or above median audit market concentration levels measured by Herfindahl index (HERF) Low and high legal regressions are respectively for the two subsamples of below or above median legal environment index (LEGAL) All regressions control for industry and year fixed effects *, **, *** significant respectively at 10%, 5%, and 1% levels with two-tailed tests of 30 Chinese provinces' comprising of the following sub-indices, namely, (1) the number of lawyers as a percentage of the provincial population, (2) the efficiency of local courts (percentage of lawsuits pursued by the courts), and (3) protection of property rights.29 As Table summarizes, POST is significantly negative (coefficient = − 0.017, t-stat = − 2.47) only for the low legal development provinces (i.e., those with legal indices less than median index for the country) but not for the high legal development group The results, consistent with Firth et al (2012a), suggest that MPR is less likely to improve audit quality in high AMC or high levels of legal development audit markets, but is more effective in provinces low levels of AMC or low levels of legal environment In the foregoing regressions, we use the median split to estimate separate regressions for high versus low AMC subsamples and also high versus low legal development subsamples The reason for estimating separate regressions is that the relation between audit quality and control variables (e.g IBIG4) likely varies with high versus low AMC and legal development For example, in Table 4, the coefficients of IBIG4 and CLIENTP are significant in the low AMC group but not in the high AMC group Consequently, estimating one single regression would force equality of coefficients on the control variables in this regression that could potentially bias the coefficient of POST, the postMPR year indicator variable To test hypothesis H3, we estimate the effect of MPR on audit quality with provincial AMC in interaction with the provincial legal development in empirical tests Table presents the regression results of the two groups with low AMC and low legal development (low–low) versus those with high AMC and high legal development (high–high) based on medians of these variables To save space, we only report the results of Eq (3) with the POST variable to capture the overall change in audit quality after MPR The regression results are similar when we substitute Y6, Y7 and Y8 indicator variables for POST in regression models (results un-tabulated) For the low–low group, the POST variable is significantly negative at less than 1% level (coefficient = −0.027, t-stat = −2.74) The results from the high–high group show insignificant change in audit quality in the post-MPR period The results (un-tabulated) are also insignificant for the two middle groups, namely, the low AMC and high legal development and the high AMC and low legal development provinces We also estimate a single regression with the full sample where POST interacts respectively with the AMC variable (LHERF) and the legal environment variable (LLEGAL) The regression includes a two-way interaction of LHERF ∗ LLEGAL, and a three-way interaction of POST ∗ LHERF ∗ LLEGAL In order to simplify the interpretation of the coefficient signs, we reverse decile rank both the provincial Herfindahl indices and the provincial legal development indices For example, the variable LHERF is set to one for provincial Herfindahl indices that are included in the lowest decile of observations Conversely, LHERF is set to zero for Herfindahl indices falling in the highest decile rank LHERF takes values between zero and one for the intervening Herfindahl indices.30 We repeat this procedure for the legal development index variable, LLEGAL Decile ranking provides more information in the variable measures relative to binary indicator measures Consistent with our decile ranking approach, in the following discussions, LL provinces are those that have the lowest AMC decile rank and the lowest legal development index decile rank as well For these provinces, both LHERF and LLEGAL take the value of one Similarly, the HH provinces reflect the highest AMC decile and highest legal development index decile, with LHERF and LLEGAL both taking the value of zero.31 Table shows that audit quality improves in the LL (LHERF = and LLEGAL = 1) provinces in the post-MPR period, but not in the HH provinces (LHERF = and LLEGAL = 0) Note that the change in the (pre- versus post-MPR) audit quality in LL provinces, after controlling for covariates, equals the sum of coefficients of POST + POST ∗ LHERF + POST ∗ LLEGAL + POST ∗ LHERF ∗ LLEGAL Since the coefficient on POST is insignificantly different from zero, and all the other foregoing 29 The index is obtained from the National Economic Research Institute (NERI) Index of Marketization of China's provinces in 2000 to measure the quality of market-supporting institutions at the provincial level The NERI Index project was sponsored by the National Economic Research Institute and the China Reform Foundation and conducted by Fan, Wang, and Zhu (2004) 30 Setting the lowest value to zero and the highest value to one is convenient for the interpretation of coefficients The intervening eight values are set to 1/9, 2/9, …, up to 8/9 consistent with the Proc Rank procedure under SAS 31 Note that in Table 4, we use median-based ranks to define low–low/high–high groups; in Table 5, we used decile-based ranks to define LL/HH groups Please cite this article as: Bandyopadhyay, S.P., et al., Mandatory audit partner rotation, audit market concentration, and audit quality: Evidence from China, Advances in Accounting, incorporating Advances in International Accounting (2013), http://dx.doi.org/10.1016/j.adiac.2013.12.001 S.P Bandyopadhyay et al / Advances in Accounting, incorporating Advances in International Accounting xxx (2013) xxx–xxx 11 Table Audit quality pre versus post-MPR: conditioning on AMC/legal environment D.V = DA Pred Sign Low–Low High–High Coef POST POST ∗ LHERF POST∗ LLEGAL POST∗ LHERF∗ LLEGAL LLEGAL LHERF LHERF∗ LLEGAL IBIG4 CBIG10 FT SIZE CFO GROW AGE SOE LEV TTYPE EXP CLIENTP Constant Obs no Adj R2 (%) +/− +/− − +/− + + + − − − + − + − +/− ? ? − + ? (t-stat) Coef −0.027*** (−2.74) 0.003 −0.051** −0.019 0.003 0.021*** −0.623*** −0.086* 0.002 0.021* −0.127*** 0.034** 0.266 0.035 −0.303* 232 47.68 (−2.16) (−1.41) (0.54) (3.06) (−8.96) (−1.83) (1.36) (1.90) (−4.45) (2.45) (0.72) (0.33) (−1.79) −0.037** 0.002 −0.008 0.018*** −0.810*** 0.041* 0.002* 0.003 −0.087*** 0.028 0.192 0.042 −0.451*** 211 79.2 Full Sample (t-stat) Coef (0.32) (−2.34) (0.26) (−1.47) (3.82) (−17.34) (1.74) (1.72) (0.36) (−3.44) (1.52) (1.13) (0.53) (−4.08) POST + POST∗ LHERF + POST∗ LLEGAL + POST∗ LHERF∗ LLEGAL LHERF + LLEGAL + LHERF∗ LLEGAL POST + POST∗ LHERF + POST∗ LLEGAL + POST∗ LHERF∗ LLEGAL +LHERF + LLEGAL + LHERF∗ LLEGAL (t-stat) 0.000 −0.022* −0.014** −0.011*** 0.016** 0.021*** 0.019*** −0.018* −0.002 0.000 0.015*** −0.665*** 0.001 0.001* 0.009** −0.084*** 0.012* −0.018 0.053 −0.292*** 876 56.32 Chi-Square −0.047*** 0.056* 0.009** (0.03) (−1.80) (−2.31) (−2.60) (2.37) (2.91) (2.51) (−1.86) (−0.41) (−0.05) (6.40) (−22.80) (0.03) (1.67) (2.13) (−6.49) (1.80) (−0.23) (1.31) (−5.08) 7.69 2.85 3.58 See Appendix for variable definitions Low–Low and High–High regressions are respectively for the two subsamples with both audit market concentration (HERF) and legal environment index (LEGAL) levels below or above their median values Variable LHERF is reversely ranked HERF deciles scaled between zero and one, with zero as the highest decile and one as the lowest decile HERF values Similarly, LLEGAL is reversely ranked LEGAL values scaled between zero and one, with zero as the highest decile and one as the lowest decile LEGAL values All regressions control for industry and year fixed effects *, **, *** significant respectively at 10%, 5%, and 1% levels with two-tailed tests coefficients are negative and significant, these results are consistent with smaller income-increasing discretionary accruals (or improved accrual quality) for the LL provinces after MPR The sum of these coefficients is − 0.047 and significantly different from zero (Chi-Square = 7.69, p b 0.001) The difference in (pre- versus post-MPR) audit quality in HH provinces is reflected by the coefficient on the POST variable, which is insignificantly different from zero, indicating no change in the audit quality of these provinces in the post-MPR period, after controlling for covariates Moreover, Table also shows that the audit quality in HH provinces is superior to that in LL provinces, both before and after MPR is introduced Specifically, the sum of the coefficients of LLEGAL + LHERF + LHERF ∗ LLEGAL reflects the difference in the audit quality (DA) of LL provinces relative to that of the HH provinces in Year (the last year prior to MPR), after controlling for covariates All these coefficients are positive and significant, and their sum is 0.056 and significantly different from zero (ChiSquare = 2.85, p b 0.10) This indicates that LL provinces exhibit lower Table Audit quality pre versus post-MPR: sensitivity tests Low–Low High–High Coef (t-stat) Coef (t-stat) Alternative audit quality measure D.V = DWCA Obs no −0.060* 230 (−1.84) −0.273 203 (−0.90) Alternative sample Add Years and data Obs No Remove Years and audit partner change obs Obs no −0.025*** 387 −0.029*** 205 (−2.92) 0.009 309 0.002 176 (1.12) Alternative Herfindahl indices Client sales revenue by province–year Obs no Audit fees within Big international accounting firms by province–year Obs no Audit fees within Big 10 domestic accounting firms by province–year Obs no −0.016* 202 −0.020** 213 −0.036*** 211 (−1.72) −0.002 193 0.005 195 0.002 179 (−0.22) (−2.96) (−2.40) (−4.30) (0.30) (0.44) (0.25) See Appendix for variable definitions Low–Low and High–High regressions are respectively for the two subsamples with both audit market concentration (HERF) and legal environment index (LEGAL) levels below or above their median values To save space, Table summarizes the coefficients of only POST variables in alternative sensitivity check regressions All regressions control for industry and year fixed effects *, **, *** significant respectively at 10%, 5%, and 1% levels with two-tailed tests Please cite this article as: Bandyopadhyay, S.P., et al., Mandatory audit partner rotation, audit market concentration, and audit quality: Evidence from China, Advances in Accounting, incorporating Advances in International Accounting (2013), http://dx.doi.org/10.1016/j.adiac.2013.12.001 12 S.P Bandyopadhyay et al / Advances in Accounting, incorporating Advances in International Accounting xxx (2013) xxx–xxx audit quality (greater income-increasing DA values) relative to HH provinces in Year In the post-MPR period, the difference in audit quality between LL versus HH provinces, after controlling for covariates, is the sum of coefficients of LLEGAL + LHERF + POST ∗ LHERF + POST ∗ LLEGAL + LLEGAL ∗ LHERF + POST ∗ LLEGAL ∗ LHERF The sum of these coefficients is 0.009 and significantly different from zero (ChiSquare = 3.58, p b 0.001) This indicates that MPR helps narrow, but does not eliminate, the difference in audit quality between the LL and HH provinces Note that while the difference in DA values between the LL and HH provinces decreases from 0.056 in Year to 0.009 after MPR, the audit quality of LL provinces is still lower In summary, Table results suggest that in the post-MPR period, audit quality improves the most for client firms in low AMC and low legal development provinces Firth et al (2012a) document the effectiveness of MPR in low legal development provinces in China In contrast, we show that AMC and legal development both incrementally moderate the effect of MPR on audit quality Our results imply that the positive effect of MPR on audit quality occurs to clients in legally less developed provinces that have low AMC, where audit quality is low to begin with 5.4 Sensitivity analyses We check the robustness of our results with an alternative earnings quality measure used by Carey and Simnett (2006), namely, discretionary working capital accruals (DWCA) The value of DWAC in year t equals current realized working capital (WCt) minus the expected level of working capital needed to support the current level of sales (WCt − 1/St − 1) ∗ St) We estimate Eq (3) after replacing the dependent variable DA with DWAC As Table summarizes, the POST variable is significantly negative (coefficient = − 0.060, t-stat = − 1.84) for the low–low provinces, but insignificant for the high–high provinces grouped by the median values of AMC and legal development Therefore, our results hold when we use DWAC as a measure for audit quality In the foregoing tables, we compare the pre-MPR Year earnings' quality with post-MPR Years 6, 7, and In our sensitivity analysis, we compare the pre-MPR Years 3, 4, and to post-MPR Years 6, 7, and with symmetric three-year periods both before and after MPR This approach addresses potential unknown bias in the last pre-MPR year precisely because it is the last year for the audit partner who is rotated off.31 Table shows that our results continue to hold with a significantly negative coefficient on POST at less than 1% level (coefficient = −0.025, t-stat = −2.92) As we mentioned before, some client firms in our sample change audit partners in Years or In our sensitivity checks, we eliminate these Years and observations that are associated with audit partner changes The two post-MPR years' partner rotations could be mandatory (the second audit partner also finishes five-year tenure after Year 6; 47 observations) or voluntary (before finishing the five-year tenure; 71 observations) Our results not change after removing these 118 observations Table shows that the coefficient of the POST variable is significantly negative, with p b 0.01 (coefficient = −0.029, t-stat = −2.96) for the low–low provinces, but insignificant for the high–high provinces Table also reports the regression results using alternative AMC Herfindahl indices Our results hold for all three alternative Herfindahl index measures at the province–year level calculated by (1) client companies' sales revenues for all audit firms, (2) audit fees within Big international audit firms, and (3) audit fees within the top 10 Chinese audit firms 32 The coefficients of POST are all significantly negative for the low–low provinces but not the high–high 31 We thank our anonymous reviewer for this suggestion We also a robustness check using the Herfindahl index computed by client companies' assets The results (un-tabulated) hold We derive these alternative AMC measures based on prior research, such as Wolk, Michelson, and Wootton (2001) and Francis et al (2013) 32 Conclusions Our research examines audit quality in China in the years immediately following mandatory audit partner rotations Using a sample of 273 Chinese firms that are subject to mandatory audit partner rotations, we provide evidence of the consequences of mandatory audit partner rotation on discretionary accruals, a proxy of earnings (audit) quality We find that while audit quality in the first post-rotation year (Year 6) is not significantly different from that in the final pre-rotation year (Year 5), audit quality does improve significantly in the two subsequent years (Years and 8) This is a new result because prior research on audit partner rotation focuses on changes to audit quality only in the first year after mandatory rotation and largely finds no evidence of improvement in audit quality We extend the focus of our study to three years post-rotation, on the ground that new rotated-in audit partners likely face a learning curve in a new audit engagement after taking over clients from incumbent audit partners We document an improvement in audit quality following mandatory audit partner rotation, particularly in Years and We condition our tests on two factors that exhibit significant variation across different Chinese provinces We find that audit quality in the post-rotation period improves in provinces that exhibit not only low audit concentration (high audit competition) but also low levels of legal development In contrast, mandatory audit partner rotation does not have any significant effect on clients located in provinces that exhibit high audit market concentration levels and high legal development levels, where audit quality is higher even in the pre-rotation period Mandatory audit partner rotation helps narrow the difference in audit quality of low concentration/low legal development provinces versus high concentration/high legal development provinces, but it does not eliminate the difference completely Our results are robust to our alternative audit quality measure and alternative samples The overall positive audit quality effect of mandatory audit partner rotation in the less legally developed provinces with low levels of audit market concentration suggests that the rule is likely to enhance audit quality in jurisdictions that have low audit quality to begin with and thus need it the most Our results also indicate that the effects of MPR on audit quality cannot be generalized and must be evaluated on a case-by-case basis in different audit markets Appendix Categorization of mandatory partner rotation Mandatory audit partner rotation year 2004 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 A (Year 1) A (Year 2) A (Year 3) A (Year 4) A (Year 5) B (Year 6) B (Year 7) Year 2005 A (Year 1) A (Year 2) A (Year 3) A (Year 4) A (Year 5) B (Year 6) Year Year 2006 A (Year 1) A (Year 2) A (Year 3) A (Year 4) A (Year 5) B (Year 6) Year Year 2007 A (Year 1) A (Year 2) A (Year 3) A (Year 4) A (Year 5) B (Year 6) Year Year 2008 A (Year 1) A (Year 2) A (Year 3) A (Year 4) A (Year 5) B (Year 6) Year Year 2009 A (Year 1) A (Year 2) A (Year 3) A (Year 4) A (Year 5) B (Year 6) Year Year Appendix describes the method to classify an audit partner change as mandatory audit partner rotation For example, if an audit partner “A” had audited a client in the past five consecutive years from 1999 to 2003, and was replaced by audit partner “B” in the sixth year (2004), we categorize this audit partner change as mandatory audit partner rotation The first MPR year is 2004; the last MPR year is 2009 Our postMPR period includes Year 6, Year 7, and Year Please cite this article as: Bandyopadhyay, S.P., et al., Mandatory audit partner rotation, audit market concentration, and audit quality: Evidence from China, Advances in Accounting, incorporating Advances in International Accounting (2013), http://dx.doi.org/10.1016/j.adiac.2013.12.001 S.P Bandyopadhyay et al / Advances in Accounting, incorporating Advances in International Accounting xxx (2013) xxx–xxx 13 Appendix Variable definitions Variable Definitions DA Discretionary accruals derived from modified Jones model (Dechow et al., 1995) matched by performance (Kothari et al., 2005), estimated with the entire CCER TotalAccrualst =Assetst1 ẳ ỵ 1=Assetst1 ị ỵ β1 ðΔSt −ΔARt Þ=Assetst−1 database sample from the corresponding industry–year regression: ỵ2 PPEt1 =Assetst1 ị ỵ ROAt1 ỵ t where Total Accruals equals net income before extraordinary items minus operating cash flows DA equals the deviation of total accruals from the model predicted values The industry category follows the 13-industry codes announced by CSRC Each industry–year regression requires a minimum of 15 observations Discretionary working capital accruals It equals current realized working capital (WCt) minus the expected level of working capital needed to support the current level of sales (WCt − 1/St − 1)*St Y6 is an indicator variable that equals one for the first post-mandatory rotation year (Year 6) and zero otherwise; Y7 equals one for Year and zero otherwise; Y8 equals one for Year and zero otherwise Post-mandatory rotation period indicator variable; equals one for the first three years subsequent to the mandatory rotation (Years 6, 7, and 8), and zero otherwise Audit market concentration measured by Herfindahl index of audit firms' audit fee income at the province level It equals the sum of squared audit fee shares of all audit firms in a province Reversed decile rank in the provincial Herfindahl index (HERF) We scale the reversed rank between zero and one LHERF equals one for provincial Herfindhal indices that are included in the lowest decile of observations; zero for the highest decile rank Legal environment index at the province level, from Table A1 of Wang et al (2008) Reversed decile rank in the provincial legal environment index (LEGAL) We scale the reversed rank between zero and one LLEGAL equals one for provincial legal environment indices that are included in the lowest decile of observations; zero for the highest decile rank An indicator variable that equals one if a company is a state-owned enterprise and otherwise An indicator variable of big audit firms that equals one for big international audit firms and zero otherwise An indicator variable of big audit firms that equals one for top 10 Chinese audit firms and zero otherwise Client company size variable, which equals the natural log of total assets Client cash flows from operation (scaled by lagged assets) The growth in sales, measured as the industry total sales of the auditor rotation year t scaled by the industry total sales of year t − Audit firm tenure counting from 2004, the first year that the audit firm data became available in CCER database No of years since a client company was first listed in Chinese stock exchanges And indicator variable that equals one if a client company was listed as ST/*ST company by the Chinese Stock Regulatory Committee in the period of Year to Year 6, and zero otherwise Leverage ratio that equals total liability scaled by total assets Two incumbent audit partners' experience in auditing clients in the same industry as their current client, measured as the sum of each audit partner's percentage of their audited same-industry assets out of the total industry assets The industry category follows the 13-industry codes announced by China Securities Regulatory Commission (CSRC) Client power measured as the percentage of a client's total assets out of an audit firm's total audited assets DWCA Y6; Y7; Y8 POST HERF LHERF LEGAL LLEGAL SOE IBIG4 CBIG10 SIZE CFO GROW FT AGE TTYPE LEV EXP CLIENTP References Aharony, J., Lee, C J., & Wong, T J (2000) Financial packaging of IPO firms in China Journal of Accounting Research, 38(1), 103–126 Arel, B., Brody, R., & Pany, K (2005) Audit firm rotation and audit quality CPA Journal, 36–39 (January) Balsam, S., Krishnan, J., & Yang, J S (2003) Auditor industry specialization and earnings quality Auditing: A Journal of Practice and Theory, 22(2), 71–97 Belsley, D A., Kuh, E., & Welsch, R E (1980) Regression diagnostics: Identifying influential data and sources of collinearity New York: John Wiley and Sons Carcello, J V., & Nagy, A L (2004) Audit firm tenure and fraudulent financial reporting Auditing: A Journal of Practice and Theory, 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Chinese audit market than large foreign Big audit firms Please cite this article as: Bandyopadhyay, S.P., et al. , Mandatory audit partner rotation, audit market concentration, and audit quality: Evidence. .. a fiscal year end of December 31 18 Please cite this article as: Bandyopadhyay, S.P., et al. , Mandatory audit partner rotation, audit market concentration, and audit quality: Evidence from China, ... years, it is de-listed Please cite this article as: Bandyopadhyay, S.P., et al. , Mandatory audit partner rotation, audit market concentration, and audit quality: Evidence from China, Advances