SSRN-id1969387-ssddd

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AUDIT FIRM ROTATION IN THE PUBLIC SECTOR:

IMPLICATIONS FOR EARNINGS QUALITY

Christofer AdrianFaculty of Business and Economics

Macquarie UniversityEmail: [email protected]

*Dr Sue WrightAssociate Professor

Faculty of Business and EconomicsMacquarie UniversityPhone: 02 9850 8521

Email: [email protected]

Dr Kym Butcher

Lecturer in AccountingSchool of Business

University of Western SydneyPhone: 02 9685 9159

Email: [email protected]

February 2012

*Corresponding author

Acknowledgements: This paper is based on a thesis completed in partial fulfillment of the requirements of an

honours degree at Macquarie University undertaken by Christofer Adrian during 2010. The authors are grateful

for the provision of data by one of the co-authors, Sue Crowe, Jill McKinnon and Phillip Ross. The paper has benefited from the helpful comments provided by colleagues at presentations of the paper at the University of

Western Australia, School of Accounting, Seminar series in March 2011 and the University of Western Sydney,School of Accounting, seminar series in September 2011.

mailto:[email protected]












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AUDIT FIRM ROTATION IN THE PUBLIC SECTOR:

IMPLICATIONS FOR EARNINGS QUALITY

Abstract

Purpose: This paper examines the effect of audit firm rotation on earnings quality in the

context of local government in Australia. In the Australian state of N.S.W., compulsory audit

tendering by local councils every six years was introduced in 1993, giving local councils the

choice to rotate or retain their audit firm. The study examines the differences in earnings

quality in the first year after the tender, between councils that retain the incumbent auditor and councils that rotate their audit firm. It also examines the differences in the quality of

earnings longitudinally, for both sets of councils, over the period from 1994 to 2006.

Design/Methodology/Approach: Using annual report data collected from over 150 NSWlocal councils between 1994 and 2006, we estimate earnings management using two methods.

Patterns in the level of earnings management between groups and over time are identified by

modeling earnings management as a function of various determinants of earnings quality and

of the year of the tender cycle.

Findings: This study finds some evidence that audit firm rotation improves earnings quality.

In the first year after the tender, earnings quality is higher for councils that rotate auditors.Over the period of the audit tenure, the pattern of earnings management differs between

councils that retain their audit firm and those that rotate audit firms, and it appears that

rotators realize improvements in earnings quality more quickly than do retainers. There is noevidence of loss of earnings quality in the year prior to the new tender.

Practical Implications: This study may encourage the introduction of audit firm rotation in

jurisdictions concerned with auditor independence.

Originality/Value: This is the first study to examine the impact of audit firm rotation on

earnings management.

Key words: local government, auditor rotation, audit tendering, earnings management

JEL classif ication: H72, H83, M42

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1. Introduction

Auditor independence is critical to an effective audit process (Australian Treasury, 2010),

with a quality audit mitigating impairment in earnings quality (Krishnan, 2003). Strong

auditor-client relationships are known to result in long tenure which has a potentially negative

impact on auditor independence (Beattie & Fearnley, 1998). This is due to the audit team

becoming accustomed to the accounting practices of the entity and therefore being unable or

unwilling to consider alternative approaches, or to adopt „fresh‟ viewpoints (Winters, 1976;

Brody & Moscove, 1998; Dopuch et al., 2001) and hence being unable to detect earnings

management. Audit procurement mechanisms such as rotation of the audit firm or the audit

partner, have been introduced as methods of overcoming the independence concerns

surrounding long auditor-client relationships, because to enhance auditor independence it is

argued that firms must rotate their auditors after a certain period (U.S. Senate, 1976).

However, whether earnings quality is impaired or improved by the improved independence

benefits of auditor rotation is under-researched with the only prior study examining auditor

rotation and earnings quality being conducted by Chen, Lin and Yin (2008) in the context of

audit partner rotation and finding no evidence that audit partner tenure improves or impairs

earnings quality. Thus our study contributes to the literature on auditor rotation literature

providing evidence as to whether audit firm rotation enhances earnings quality.

Research opportunities to examine audit firm rotation are not easy to find. The adoption of

Compulsory Audit Tendering (CAT) in N.S.W. since 1994 gives an ideal setting for such

research, because some councils have rotated their audit firms, and some have not. Using this

setting, prior literature has established (i) a large and sustained audit fee decline at the time of

its implementation (Boon, McKinnon & Ross, 2005), yet (ii) no impairment of audit quality

(Boon, McKinnon & Ross, 2007; Butcher, Harrison, McKinnon & Ross, 2011). However, the

effects of audit firm rotation on earnings quality have not been examined in this setting, and

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this paper contributes to the literature on audit firm rotation.1

When a change of audit firm is

being evaluated, there is a trade-off between the independence of the new auditor and the

client-specific knowledge (expertise) of the old auditor (Butterworth & Houghton, 1995). On

the one hand, auditor rotation is argued to enhance audit independence because the threat of

familiarity is minimized (Arrunada & Paz-Ares, 1997). On the other hand, it also leaves the

new auditor without expertise or client-specific knowledge, which is likely to result in a lower

audit quality and hence reduced likelihood of detecting material misstatements.

The results of this study also extend the findings of Pilcher and van der Zahn (2010) and

Stalebrink (2007) which examine earnings management in the local government settings of

Australia and Sweden respectively. These studies assert that depreciation is the main method

of manipulating earnings through discretionary accruals because depreciable assets comprise

a significant proportion of local council balance sheets and the maintenance of those assets is

their main operational activities. For example, Pilcher and van der Zahn (2010) argue that

local councils may utilise unexpected depreciation to manipulate financial performance in

order to get a higher level of capital contributions from higher government authorities.

However, Pilcher and van der Zahn (2010) do not find strong evidence to conclude that NSW

local governments are utilizing depreciation to manage earnings in achieving a break-even net

income, and argue that accruals models other than depreciation models may be needed to

investigate earnings management practice in local government.

In summary, the purpose of this study is to examine whether the rotation opportunity

provided by compulsory audit tendering has an impact on earnings management for NSW

local councils. The study firstly examines the differences in earnings management for

councils that reappoint the incumbent auditor (retainers) versus those that rotate audit firm

1There is a clear distinction between audit quality and earnings quality. In the literature, audit quality is defined as the auditor's ability to

detect and eliminate errors and manipulations in reported net income (Davidson & Neu, 1993). Hence, it depends primarily on the efforts and

expertise of the auditors. Earnings quality is a broader concept, defined in the literature as how the reported earnings is a good indicator for

future earnings (Penman & Zhang, 2002). Earnings quality encompasses audit quality but is influenced also by the incentives and actions of

managers to manipulate earnings.

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(rotators) in the first year after the tender, and secondly examines the differences in the

quality of earnings longitudinally, over the period from 1994 to 2006.

Section 2 provides an overview of the background of this study, and outlines the

accountability relationships that provide incentives and pressures for local councils to engage

in earnings management. Section 3 presents the literature which this study draws on, and to

which it contributes: auditing and audit rotation, and earnings management. Section 4

develops the hypotheses to be tested and presents the research design. Section 5 describes the

data. The results of hypotheses testing and further analysis are presented in Section 6,

followed by a summary of the findings, and discussion of the implications and limitations of

this study in Section 7.

2. Background

2.1 Compulsory Audit Tendering

Compulsory audit tendering (CAT) was introduced to NSW local councils in 1993 (with

the first tender occurring in 1994/95) as part of a public sector initiative to increase

accountability to the community with regard to custody and management of public money and

assets (NSW Government, 1992, p. 8). Councils tender their audit services every six years for

tenure periods of six years, with the incumbent audit firm being eligible to reapply. That is,

CAT introduces a context of voluntary audit firm rotation as local councils have the

opportunity but not the requirement to rotate audit firms every six years.

2.2 Introduction of AAS27

The introduction of compulsory audit tendering coincided with a number of other changes

to local government in N.S.W. in particular the introduction of AAS27 Financial Reporting

by Local Governments. NSW local councils now capitalize all non-current assets and value

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them at written-down replacement cost (Walker et al., 1999).2

The scale of changes to local

government accounting caused by AAS27 should not be underestimated. The bringing of non-

current assets onto the balance sheet required the councils to capitalise, value and depreciate

all infrastructure assets, including, for example, buildings of varying use and purpose, roads,

bridges, footpaths, parks, gardens and other community amenities. Many of these assets had

never been accounted for, or valued, by the councils previously. Technical implementation

issues identified by local government practitioners and regulators, reported by Ryan (1997, p.

77), delayed the adoption of AAS27, with two effects in the early years. Some non-current

assets may be incorrectly stated on the balance sheet during the implementation period, and

the number modified audit opinions should have been higher. Therefore, in examining audit

firm rotation and earnings management, this study needs to take account of the introduction

and effect of AAS27.

Stalebrink (2007) provides evidence from Swedish municipalities on two effects of the

adoption of accrual accounting, which also apply in the context of N.S.W. local councils: on

one hand it forces government to recognize transactions at the time they occur, hence

minimizing their opportunity to manipulate financial performance as they would using cash

accounting, and on the other hand, it provides an opportunity for government to engage in

earnings management.

2.3 Accountability relationships and incentives to manipulate earnings

Under agency theory, agency or accountability relationships exist between agents

(managers) and principals or stakeholders (shareholders and debtholders), and audit is

demanded to attest to the credibility of the representations made to stakeholders (Jensen &

Meckling, 1976). Agency and accountability relationships also exist in the public sector

context of local government. Local councils in Australia are established under the Local

2 AAS27 was issued in July 1990 operative initially for accounting periods ending on or after 1/7/93. Falk and Neilson (1993, p. 55) note that

“before 1 July 1993, local government units applied the cash or modified cash basis for reporting purposes”. In NSW, prior to AAS27, local

councils used a modified cash basis of accounting and had accruals for items including rates receivable, wages payable and provisions.

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Government Act in each state to service local needs, with their directors (councillors) elected

by the community they serve (McNeil, 1997). Councils are funded by the state government

through general and specific purpose grants, and by the community through rates and user

charges. The government and community delegate decision-making authority to the councils‟

managers for a range of services and regulatory functions. Hence, accountability relationships

arise between the council (its General Manager, council officers and elected councillors) and

two main stakeholders, the state government and the community. Accountability to the state

government is through the Department of Local Government. A major monitoring mechanism

of council accountability to its stakeholders is the annual report and the associated auditor‟s

report.

Given the importance of these accountability relationships we argue that councils have an

incentive to manipulate earnings to attest to superior resource management and accountability

to stakeholders, in spite of the absence of the profit motive and other incentives that apply in

the for-profit sector. In their role as providers of services to the local community, such as

community activities, waste disposal, sports facilities, and maintenance of major public

infrastructure (Pilcher & van der Zahn 2010), councils experience pressure from all funding

sources to deliver high quality and value-adding services at a reasonable cost. Both the higher

government authorities and the rate-paying public are concerned that the councils use their

resources in the most effective and efficient manner possible. Also councils face the ever-

present threat of adverse media attention should waste or fraudulent practices be suspected.

Their performance is assessed by both higher government authorities and ratepayers on the

basis of the information contained in their financial reports, which gives them an incentive to

manage earnings in order to achieve a break-even net income, rather than a higher profit

(Pilcher & van der Zahn 2010).

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3. Literature

3.1 Auditing and auditor rotation

It is recognised that there is a trade-off between the independence of the auditor and

client-specific knowledge or expertise (Butterworth & Houghton 1995). When there is a

change of auditor, independence is enhanced at the expense of expertise. Particularly

following a long auditor-client relationship, independence is improved by reducing the threat

of familiarity and bringing a “fresh look” to financial reporting (Arrunada & Pax-Ares 1997,

Lu & Sivaramakrishnan 2010). The auditors are not able to rely on previous work and so are

more attuned to finding irregularities in the reports. They have not developed confidence in

the client and so expend more effort in conducting the audit (Johnson Khurana & Reynolds

2002).

Other advantages of a change of auditor are that it results in a more rigorous audit process

(Bates Ingram & Reckers 1982) and that there is a higher likelihood of the auditors reporting

financial statement anomalies (Knapp 1991, Brody & Moscove 1998). Also auditor rotation

develops a sound perception of auditor independence, which affects financial report users‟

decision making because they rely more on financial statements that they know to be audited

(SEC 2000, Hussey & Lan 2001) and independent of other influences (Bocconi 2002).

On the other hand, a change of auditor results in lack of expertise and client-specific

knowledge for the new auditors (Bocconi 2002). It creates information asymmetry (Hamilton

Ruddock Stokes & Taylor 2005), and causes a significant learning curve for the new auditors

(Knapp 1991), who are not able to benefit from the firm-specific knowledge of the previous

auditor (Lu & Sivaramakrishnan 2010). It takes a couple of years for the new auditors to

achieve the required expertise and knowledge (St. Pierre & Anderson 1984, Bocconi 2002,

Johnson Khurana & Reynolds 2002, Myer Myer & Omer 2003). In the early years of an audit,

the auditor tends to favour the client to avoid losing the engagement (Geigher &

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Raghunandan 2002, Ruiz-Barbadillo & Gomex-Aguilar 2002). Also, a change of auditor

results in an increase in costs incurred by both auditors and management (Bocconi 2002,

Jackson Moldrich & Roebuck 2008).

3.2 Earnings management and auditor rotation

Earnings management is a deliberate intervention in the financial reporting process to

obtain private benefits (Schipper 1989), involving the manipulation of financial reports

through management use of judgment and discretion (Healy & Wahlen 1999). Traditionally,

earnings management has been proxied by discretionary accruals, measured as the residual

from models that relate total accruals to underlying economic activity, following Jones

(1991), Dechow Sloane and Sweeney (1995) and Kothari, Leone and Wesley (2005), and

from models that relate earnings to cash flows, following Dechow and Dichev (2002). As

noted previously, in the public sector, Stalebrink (2007) finds some evidence of accruals

management using depreciation charges in Swedish municipalities, but Pilcher and van der

Zahn (2010) do not find similar evidence for NSW local councils.

With regards to previous studies about the relationship between auditor rotation and

earnings quality, the only evidence relates to the context of partner rotation. Chen, Lin and

Yin (2008) find that there is no evidence that audit partner rotation improves earnings quality.

Furthermore, they also found no evidence that long audit partner tenure impairs earnings

quality. As noted previously, no previous research has examined earnings management and

auditor rotation in the public sector.

4. Hypotheses Development and Research Design

4.1 Hypotheses Development

Based on auditor rotation and earnings quality literatures, three hypotheses are developed

in relation to the research question, which is, does audit firm rotation improve earnings

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quality? The first hypothesis examines the difference in earnings management (proxied by

discretionary accruals) between rotators and retainers in the first year after the tender. The

other two hypotheses focus on the difference between rotators and retainers, and ascertain

earnings management varies according to council‟s decision to rotate or retain their

incumbent auditor.

Using theoretical arguments, we examine different time periods within the six year tender

period. They are (1) the first year after the tender, (2) the middle years of the tender (the

second through to the fifth year after the tender), (3) the last year of the tender, (4) the early

years (the first through to the third year), and (5) the later years (the fourth through to the

sixth year). The comparisons are between (a) the first year and the middle years, (b) the

middle years and the last year, and (c) the early years and the later years. These comparisons

are illustrated in Appendix 1. Those councils that rotated to a new auditor (“rotators”) are

examined separately from those that retained their audit firm (“retainers”).

INSERT APPENDIX 1 HERE

4.2 Hypotheses

Hypothesis 1

The first hypothesis compares earnings management in the first year after the tender

between rotators and retainers to examine the effect on earnings quality of rotating the audit

firm. The comparison is made in the first year after the tender because it is expected that the

greatest difference in earnings management between rotators and retainers will occur in the

first year.

A decrease in earnings management for rotators compared to retainers may indicate that

rotation is an effective mechanism for overcoming agency problems that occur in local

government, that is, information asymmetries between the principal (stakeholders of State

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Government and community/rate-payers) and the agent (local councils) (Broadbent, Dietrich

& Laughlin, 1996).

On the one hand, auditor rotation overcomes the familiarity threat to independence as a

new audit firm is likely to conduct a more rigorous audit process, which includes setting a

lower materiality threshold (Bates, Ingram, & Reckers, 1982), resulting in both a greater

chance of detecting earnings management and a disincentive for councils to engage in

earnings manipulation. On the other hand, auditor rotation may cause information asymmetry

for the new auditors due to the steep learning curve and their lack of specific expertise, and

thus may result in a lower quality audit, a higher likelihood that council‟ s creative accounting

will escape detection and hence lower earnings quality

Motivated by these arguments for and against the impact of auditor rotation on the quality

of earnings, the first hypothesis examines the association between the council‟s decision to

rotate or retain incumbent auditors and the quality of earnings. Given that the high incidence

of lengthy auditor client relationships was a motivation for introducing compulsory audit

tendering (NSW Local Government, 1992) and that following long auditor tenure periods the

familiarity threat to independence is overcome, at the expense of expertise, by introducing

„fresh eyes‟ to financial reporting (Arrunada & Pax-Ares 1997, Lu & Sivaramakrishnan 2010)

we expect that the independence argument dominates the lack of expertise argument. Hence

the hypothesis is stated in a directional form, as follows:

H1: Earnings quality will be higher for councils that rotate their audit firm than for those

that retain their audit firm, in the year after the tender.

Hypothesis 2 (a, b, c)

The audit firms of councils that rotate may have less incentive to favour the client at the

start of the six year guaranteed tenure period, but will face increasing incentives to favour the

client as the threat of being rotated in the next tender as it gets closer in time (Boon Crowe

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McKinnon & Ross 2005), so earnings quality could be expected to decline over the audit

tenure. On the other hand, Johnson Khurana and Reynolds (2002) and Myers Myers and

Omer (2003) propose that earnings quality will be lower in the first year of the tenure period

because of lack of expertise and client-specific knowledge of the new audit firm, so earnings

quality could be expected to rise over the audit tenure. Given these conflicting findings in the

literature, in Hypothesis Two we compare earnings quality between different periods within

the six year audit tender period, and set the relations in non-directional terms:

H 2: For councils that rotate their auditors, there is no significant difference in earnings

quality between

(a) the year after the tender and the middle years

(b) the middle years and the year prior to the next tender

(c) the early years of the tenure and the later years.

Hypothesis 3 (a, b, c)

For councils that retain their auditors, the expertise argument of Johnson Khurana and

Reynolds (2002) and Myers Myers and Omer (2003) does not apply. Earnings quality is

expected to be high at the start of the audit tenure, and no increase in quality over the tenure

period is expected. In fact, the audit firm has little incentive to favour the council in the early

years, and is likely to possess a greater ability to detect earnings management due to the level

of expertise developed from auditing the council over a long period. On the other hand, it is

expected that there are incentives for the audit firm to favour the client towards the end of the

audit tenure, in order to win the next tender, and so earnings quality is expected to decline as

the period progresses. Hypothesis Three is therefore stated in a directional form:

H 3: For councils that retain their auditors, earnings quality will be higher in

(a) the year after the tender compared to the middle years

(b) the middle years compared to the year prior to the next tender

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(c) the early years of the tenure compared to the later years.

4.3 Models

Discretionary accruals are the residuals when total accruals are estimated, using two

approaches identified from the literature: the modified Jones (MJ) model, which estimates

total accruals as a function of revenue, fixed assets and lagged return on assets, and the

Dechow and Dichev (DD) model, which estimates total accruals as a function of cash flows in

the current, prior and subsequent years.

Considering the local government context of this study, both models have their strengths

and weaknesses. While the MJ model is well established in the literature, and has been used

by many previous studies in examining total accruals, it is more oriented to profit-making

companies, which has been the focus of the majority of prior financial reporting quality

research. On the other hand, the DD model is used by Pinnuck and Potter (2009) in the

Australian local government setting. It may be more suitable for the not-for-profit sector in

which cash flows and working capital requirements are a significant component of council

activity. For councils, the essential changes in working capital are closely related to cash

flows from previous, current and subsequent years. Thus this study contributes to the

literature by using both the MJ and the DD models to capture the extent to which councils

conduct earning management practices to manipulate the reported earnings.

The hypotheses are therefore tested using two models, (i) the MJ model (i.e., Dechow,

Sloan & Sweeney 1995) and (ii) the DD (based on Dechow & Dichev (2002)). The models

are presented below as follows (excluding time and council subscripts):

Models 1 and 2 (to test Hypothesis 1)

DMJ = β0 + β1ROTATION + β2OCF + β3LEVERAGE + β4COUNSIZE + β5AFSIZE +

β6TENDER + β7 GROUP + β8 LOCATION + β9 LNINDEXAF (1)

DDD = β0 + β1ROTATION + β2OCF + β3LEVERAGE + β4COUNSIZE + β5AFSIZE +β6TENDER + β7 GROUP + β8 LOCATION + β9 LNINDEXAF (2)

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Models 3 and 4 (to test Hypothesis 2 and 3)

DMJ = β0 + β1YEAR + β2OCF + β3LEVERAGE + β4COUNSIZE + β5AFSIZE + β6TENDER

+ β7 GROUP + β8 LOCATION + β9 LNINDEXAF (3)

DDD = β0 + β1YEAR + β2OCF + β3LEVERAGE + β4COUNSIZE + β5AFSIZE + β6TENDER

+ β7 GROUP + β8LOCATION + β9 LNINDEXAF (4)

The dependent variables are:

DMJ: the absolute value of total unexpected (discretionary) accruals in year t,

calculated as the absolute value of the residual from the MJ model;

DDD: the absolute value of total unexpected (discretionary) accruals in year t,calculated as the absolute value of the residual from the DD model.3

The test variables, indicated in bold, are:

ROTATION: a dichotomous variable, coded 1 if the councils rotate, zero otherwise.

This is used in Models 1 and 2, and if significant, provides support for Hypothesis 1;

YEAR (YEAR1, YEAR6, YEAR1-3): a dichotomous variable, coded 1 if it is (a)

first year after the tender, (b) last year before the tender (c) early years of the tenure, and

zero otherwise). This is used in Models 3 and 4, and if significant, provides support for

Hypotheses 2 and 3.

The control variables are:

OCF : Operating cash flow in year t scaled by lagged total assets (TAt-1);

LEVERAGE: the ratio of total liabilities to total assets in Year t ;

COUNSIZE: the natural logarithm of total assets in Year t ;

AFSIZE : dummy variable, coded 1 if the audit firm is a Big-N audit firm, zerootherwise;

TENDER : dummy variable, coded 1 if the council‟s observation is in tender 1, zero

otherwise;

GROUP: dummy variable, coded 1 if the council‟s observation is in group 1, zero

otherwise;

LOCATION: dummy variable, coded 1 if the council is located within the SydneyMetropolitan region, zero otherwise;

LNINDEXAF: the natural logarithm of indexed audit fees.

3 Capital grants from government are excluded from revenue used in calculating the discretionary accruals and the operating cash

flows, following Pinnuck and Potter (2009). Although they can be considered as revenue because they are a major component of

council funding, they are generally classified as an equity contribution because they are provided for specific projects and tightly

audited thus decreasing the scope for earnings management (Results including capital grants are reported as an additional analysis in

Section 5.) Further, hypotheses two and three are tested separately for rotators and retainers, in order to properly test whether the

impact of compulsory audit tendering on earnings quality depends on council‟s decision to rotate or retain their audit firm.

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The control variables are included in the models for the following reasons. Firms with

higher leverage are associated with higher levels of discretionary accruals (Shan Taylor &

Walter 2010). Council size is expected to have a significant impact on discretionary accruals,

because larger firms have higher non-discretionary accruals (Dechow & Dichev 2002), and

larger organisations face higher political costs (Watts & Zimmerman 1978) which may

provide an incentive to reduce earnings. Discretionary accruals are expected to be lower for

councils that are audited by a Big N auditor, because larger audit firms have more incentives

to maintain their good reputation to protect their larger client base and so expend more effort

into detecting earnings management (Krishnan 2003). 4 Similarly, audit fees are included as

an indicator of the level of effort exercised by auditors. Finally, control variables are included

for tender to indicate whether it was the first tender (mid 1990‟s) or second tender (around

2000), for group to indicate whether the council was in the first group to go to tender in 1993

or the second group in 1994, and for location, to indicate if the council is in the metropolitan

area of NSW or otherwise, with metropolitan councils expected to have a greater opportunity

for earnings management given the greater demand for their services and hence the greater

variety, number and complexity of transactions in metropolitan areas given the higher

population density (Boon, et al., 2005).5

All of these variables may affect the association

between discretionary accruals and the year of the tenure period.

As noted previously, the introduction of AAS27 concurrent with the introduction of CAT

and the first audit tender is a confounding factor in the design of this study. Whilst any results

for the first tender cannot be solely attributed to the introduction of CAT, this limitation does

not apply to subsequent tenders. Also the initial impact of the introduction of CAT may be

greater than the impact in subsequent tenders, consistent with Boon, Crowe, McKinnon and

4 Big N represents N largest international audit firms. Big N consists of 6 audit firms from 1989 to 1998, reduced to 5 audit firms in 1998 to

2001, and 4 audit firms since 2002. There are two Big N auditors in the NSW local government audit market, only one of which is a

specialist audit firm. The number of audit firms decreased from 30 to 19 auditors over the period of the study, with the average market share,indicative of increasing specialization increasing over the period of the study (Boon et al., 2005, p.230).5 This study uses NSW Division of Local Government classification for metropolitan councils, that is, metropolitan councils are those

located within the Sydney Metropolitan region, while non-metropolitan councils are those councils located in other areas of NSW.

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Ross (2005) who found that the initial impact of CAT on audit fees was greater in the first

than the second tender.

5. Data

5.1 Sample selection

The data required in this study were collected previously by Boon, Crowe, McKinnon and

Ross (2005) for their study (see this paper for a detailed description of the data collection and

tender period identification process). The data consisted of the financial and audit

characteristics of NSW local councils over the financial years 1994 through 2008 inclusive.

Overall, there were between 172 and 177 local councils in NSW from 1994 to 2004, and

152 thereafter. The total number of councils reduced over the period of the study for several

reasons, including councils‟ amalgamations. For this study, a total sample of 107 councils was

selected because these councils went to tender at similar times thus controlling for events

affecting some councils at the time of their tenders. 17 of the 107 councils were classified as

Group 2 (commenced their first tender in 1993, their second tender in 1999-2000, and their

third tender in 2005-2006) whereas 90 of them are classified as Group 1 (commenced their

first tender in 1994-1995, their second tender in 2000-2001, and their third tender in 2006-

2007).

The remaining councils were excluded because they went to tender in different periods.

The differing times of going to tender occurred due to transitional provisions of the NSW

Local Government Act (1993) which permitted the councils to retain their incumbent auditors

for up to three years following the commencement of the Act (NSW Legislative Assembly,

November 1992). The sample selection also excluded amalgamated and/or failed council.

In running the analysis and particularly in testing the hypotheses, different sample sizes

were used according to requirements of the hypotheses and the models. The goal in each case

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was to use as many observations as were available, for the models being used. The MJ model

used 1386 council-year observations, and the DD model used 1271 council-year observations.

For separate comparisons between years of the tenure, (a) was tested on 365 rotators and 645

retainers for both models; (b) was tested on 365 rotators and 645 retainers for the MJ model

(350/630 for the DD model); and (c) was tested on 438 rotators and 774 retainers for the MJ

model (420/776 for the DD model).

5.2 Descriptive Statistics

Table 1 shows the descriptive statistics for the dependent and independent variables used

in this study. For the dependent variables, the MJ model estimates higher discretionary

accruals than the DD model. Across both models for tender 1, discretionary accruals are

higher for retainers than rotators. For tender 2, the results are model dependent: the MJ model

produces higher estimates for rotators, whereas the DD model produces higher estimates for

retainers. When capital grant are included, discretionary accruals are slightly higher.

For the independent variables, the revenue, total profits, return on assets and operating

cash flow figures indicate that retainers are larger than rotators, although less so for tender 1

than tender 2. Consistent with this, retainers pay higher audit fees, and rotators are more

highly leveraged.

INSERT TABLE 1 HERE

For the dummy variables, shown in Table 2, the descriptive statistics show that 69% are

non-metropolitan, and 75% have non-Big N audit firms, both consistent between rotators and

retainers.

INSERT TABLE 2 HERE

5.3 Correlation Analysis

The correlations between independent variables are not tabulated in this paper. There is

little indication of potential multicollinearity, because only two sets of correlations high and

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significant: Council Size and Location (0.597) and Council Size and Audit Fees (0.658).

These variables are all control variables, and so are maintained in the models in spite of the

risk of over-specification.

6. Results and Further Analysis

6.1 Results of Hypothesis Testing

Hypothesis 1

Recall that Hypothesis 1 proposes higher earnings quality (lower earnings management) in

the first year after the tender by rotators compared to retainers. Table 3 presents the results for

H1.

INSERT TABLE 3 HERE

As reported in Table 3 the results support Hypothesis 1. At the 5% significance level, a

negative association (co-efficient = -0.008, p = 0.011, and coefficient = -0.008, p = 0.002 for

model 1 and 2 respectively) is found between the level of discretionary accruals and

ROTATION. A negative association between these variables indicates that those councils that

rotated their auditors experienced lower earnings management (and higher earning quality) in

the first year after the tender compared to those councils that retained their auditors.

Hypothesis 2

Recall that Hypothesis 2 proposes that earnings management by councils that rotate their

auditors does not change between the following three comparative periods of time: (a) the

first year after the tender and the middle years of the auditor‟s tenure, (b) the middle years of

tenure and the final year of tenure, and (c) the early years of the tenure and the later years of

the tenure. The results are presented in Table 4. At the 5% significance level, a positive

association (co-efficient = 0.003, p = 0.029, and co-efficient = 0.003, p = 0.021, for model 3

and 4 respectively) is found between the level of earnings management and YEAR 1- 3. A

positive association between these variables indicates that for councils that rotated their

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auditors, discretionary accruals in the early years of the tenure period were higher than in the

later years. However, the co-efficients for YEAR1 and YEAR6 were not significant,

indicating that for councils that rotated their audit firms, there is no difference in earnings

quality between the first year of the audit firm‟s tenure and the middle years, or between the

middle years of the audit tenure and the last year. Overall, these results provide support for

Hypotheses 2a and 2b, but not for Hypothesis 2c.

INSERT TABLE 4 HERE

Hypothesis 3

Hypothesis 3 proposes that earnings quality will be higher (earnings management will be

lower) in the earlier years of the audit tenure for retainers, tested over the same three

comparative periods as for rotators. The results are also presented in Table 4. At the 1%

significance level, a positive association (co-efficient = 0.008, p = 0.000, and co-efficient =

0.005, p = 0.000 for model 3 and 4 respectively) is found between the level of earnings

management and YEAR1. Similarly, a positive association at the 1% level is found between

earnings management and YEAR 1-3 (co-efficient = 0.004, p = 0.006, and co-efficient =

0.003, p = 0.000 for models 3 and 4 respectively). These positive associations do not support

H3a and H3c. Rather than earnings quality being higher in the early years of the audit tender,

it is lower, because discretionary accruals are higher. In fact, earnings quality improves over

time. In addition, there is no significant association between earnings management and

YEAR6, and so Hypothesis 3b is not supported. For councils that retained their audit firm,

earning quality does not decline at the end of the audit tenure. Overall, the results do not

support Hypothesis 3 at all.

6.2 Further Analysis

Several additional analyses of the data were undertaken, to check the robustness and

reliability of the results. These are not reported separately in tables. First, all results were re-

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run using the Total accruals model, rather than the discretionary accruals and the results are

unchanged. Second discretionary accruals were calculated using revenue including capital

grants, and modeled against cash flows including capital grants. The results for Hypothesis

one were weaker, whilst the results of testing the hypotheses two and three were the same,

with the following exceptions. For rotators, when capital grants are included, there is no

significant difference between the first three and the last three years of the audit tenure. For

retainers, the first year has lower earnings quality than the middle years, but again there is no

significant difference between discretionary accruals in the early period and the later period.

Capital grants are variable amounts, with no discernable pattern, and so it is not surprising

that their inclusion adds noise to the analysis, and mostly affects the results that compare a

number of years of figures.

The third and fourth additional analyses are to test the hypotheses separately for each

tender, and for each group of councils. Comparing the level of discretionary accruals between

the first year and the middle years, there is a strong effect of reducing discretionary accruals

in the first tender for both rotators and retainers, and the opposite result in the second tender

for rotators. When the two tenders are combined, for retainers, these two effects offset each

other and the result is not significant, whereas for rotators the overall effect is dominated by

tender 1. A similar result is found when comparing the first three years of the tenure with the

last three years. For rotators, the two tenders have opposite impacts on the level of

discretionary accruals, although the overall result is dominated by tender 1. For retainers,

tender 1 mostly dominates. There is no difference in the results for each separate tender for

the comparison of the final year of the tender with the middle years.

The results of separate analysis of the timing of the first tender, which the majority of

councils (90) undertook in 1994 and a minority in 1993 (17), are dominated by the effects of

the larger group.

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7. Summary, Implications and Limitations

The main findings of this study are presented in Table 5. They uphold the advantage of

independence expected of a rotation of the audit firm, and provide little evidence of the

advantage of client-specific expertise from retaining the audit firm. In the first year after the

tender, earnings quality is higher for the councils that rotate their auditors compared to those

that retain their auditors. Both rotators and retainers realize improvements in earnings quality

over the period of the audit firm‟s tenure, but it appear s that retainers realize those

improvements more slowly than do rotators.

Specifically, for councils that retain their auditors, the level of earnings management is

higher in the first year after the tender than it is in the following years, whereas for councils

that rotate to a new audit firm, the level of discretionary accruals is not significantly different

in the first year after the tender compared to the following years. For both rotators and

retainers, there is a higher level of earnings management in the early years compared to the

later years. This result is consistent across the two measures of earnings management,

although it is slightly weaker when capital grants are included in the measurement of earnings

management. The results for tender 1 are generally stronger than those for tender 2, although

the results for tender 1 are confounded by the simultaneous introduction of accrual accounting

(AAS27) to N.S.W. local government at the same time as CAT. For this reason, future

research should examine earnings quality for tender 3 when the period of auditor tenure

following that tender has expired.

The results do not support the explanation that it takes some time for new auditors to

conduct an effective audit. Whilst it may take time to build expertise and client specific

knowledge over several audits, our evidence shows that disadvantage being outweighed by

the advantage of going to the new audit with “fresh eyes”. For rotators, earnings management

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is lower in the later years of the tenure, but it is less than that of retainers from the first year of

the audit tenure period.

The results do not provide support for the prediction that the auditors will favour the

clients towards the end of the audit tenure. For both retainers and rotators, the discretionary

accruals are higher in the first year than the subsequent years, and they are not higher in the

last year. One possible explanation is that audit fees from local government are low.6

This

provides little incentive for the incumbent auditor to favour the client to attract a re-

appointment because of the low return.

The design of this study is subject to limitations due to its context. First, councils can elect

to rotate their auditor, and so these results may not be generalizable to a context in which

rotation is mandatory. Second, we only use one proxy for earnings management, that is,

discretionary accruals. Future research could usefully re-examine the impact of compulsory

audit tendering on earnings management using other proxies such as earnings re-statements.

This study contributes to the literature on local government and the practice of earnings

management in an environment characterized by different incentives and different accounting

transactions compared to the for-profit sector. It also contributes to the literature on earnings

management and auditor rotation, by assessing the impact of audit firm rotation on measures

of earnings management.

6Boon, Crowe, McKinnon and Ross (2005) find that CAT resulted in a 40% decrease in audit fees.

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Appendix 1

COMPARISONS BETWEEN YEARS OF THE TENDER

(a) The first year and the middle years

1 2 3 4 5 6

(b) The middle years and the last year

(c) The early years and the later years

1 2 3 4 5 6

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TABLE 1

DESCRIPTIVE STATISTICS FOR DEPENDENT AND INDEPENDENT CONTINUOUS VARIABLES

PANEL A DEPENDENT VARIABLES

All Years Tender 1 Tender 2

Min Max Mean Median StDev Min Max Mean Median StDev Min Max Mean Median StDev

DMJ All 1.31E-05 0.240265 0.013283 0.009217 0.017571 2.94E-05 0.240265 0.016067 0.010218 0.023339 1.31E-05 0.082668 0.010869 0.008762 0.009686

Rotators 1.55E-05 0.132437 0.01284 0.009793 0.012971 2.94E-05 0.132437 0.014007 0.01063 0.014701 1.55E-05 0.059924 0.011173 0.008779 0.009632

Retainers 1.31E-05 0.240265 0.01351 0.008979 0.019511 0.000137 0.240265 0.017501 0.010036 0.027741 1.31E-05 0.082668 0.010736 0.008762 0.009717

DDD All 7.15E-06 0.187253 0.010222 0.007029 0.013189 1.11E-05 0.187253 0.012419 0.007356 0.017184 7.15E-06 0.061356 0.008059 0.006679 0.006711

Rotators 7.15E-06 0.174295 0.009715 0.006731 0.012815 1.11E-05 0.174295 0.011279 0.007423 0.015867 7.15E-06 0.029598 0.007579 0.006327 0.006254

Retainers 9.31E-06 0.187253 0.010502 0.007097 0.013391 0.000166 0.187253 0.013213 0.00735 0.018022 9.31E-06 0.061356 0.008272 0.006871 0.0069

Where:

DMJ: total unexpected accruals in year t as the absolute value of the residual in model MJ;

DDD: total unexpected accruals in year t as the absolute value of the residual in model DD;

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PANEL B INDEPENDENT VARIABLES

All Years Tender 1 Tender 2

Min Max Mean Median Std

Dev.


Dev.


Dev.EVENUE

($000)

All

Rotators

Retainers

3258

4370

3258

186196

186196

182183

33514

28516

36070

20108

17543

22723

33532

30793

34588

3258

4370

3258

135131

135131

126056

27548

24521

29656

17124

13945

19367

27067

24821

28369

3947

5207

3947

183656

183656

179039

37345

32772

39350

22747

21495

25189

36312

35104

36689

ECEIVAB

LES

($000)

All

Rotators

Retainers

30

23630

29573

2692229573

3189

28423366

2042

27542265

3555

40233278

30

23730

26922

2692213142

2619

23802786

1685

14071854

3186

38952573

200

236200

29573

2533229573

3545

33553628

2446

21072588

3657

40023497

PPE

($000)

All

Rotators

Retainers

2167

8055

2167

4065766

1990579

4065766

422385

368551

449919

207582

176789

235505

553736

448536

598820

8055

8055

9885

4065766

1990579

4065766

396064

395423

396509

183750

175602

210969

529813

474486

565755

2167

23860

2167

4059094

1612958

4059094

427346

334957

467845

205695

180360

258534

553863

413434

601201

PROFIT

($000)

All

RotatorsRetainers

-26114

-12973

-26114

57957

18899

57957

-290

-537

-164

-381

-280

-408

4371

3123

4885

-26114

-12973

-26114

17245

11980

17245

-885

-943

-844

-825

-420

-1069

3622

3059

3970

-17283

-11752

-17283

29964

13014

29964

168

-42

260

-139

-118

-149

4031

2812

4461

. ASSETS

($000)

All

Rotators

Retainers

12317

12137

15298

4152845

2014233

4158245

450808

391767

481005

229600

192623

254250

573145

464354

619536

12317

12317

15298

4104572

2014233

4104572

416903

413616

419191

196273

190340

241396

542158

485175

579142

29871

29871

44615

4152845

1728359

4152845

460744

363909

503192

234732

194316

288712

576508

436433

623868

ROA AllRotators

Retainers

-0.18647-0.18647

-0.06605

0.133540.07536

0.13354

-0.00066-0.00080

-0.00059

-0.00108-0.00079

*0.00122

0.018290.01999

0.01736

-0.18647-0.18647

-0.06605

0.133540.07536

0.13354

0.00028-0.00024

0.00064

-0.00130-0.00061

-0.00227

0.024260.02485

0.02386

-0.05518-0.04156

-0.05518

0.051410.02510

0.05141

-0.00191-0.00174

-0.00198

-0.00123-0.00091

-0.00133

0.011160.01128

0.01111

PERATIN

G CASH

FLOW

($000)

All

Rotators

Retainers-48163

-15156

-48163

240102

40686

240102

5015

4076

5495

2840

2511

3036

9108

5884

10347

-16351

-11253

-16351

240102

34813

240102

4374

3286

5131

2392

2154

2596

10871

4514

13605

-48163

-15156

-48163

43239

40686

43239

5229

4835

5402

3207

3382

3182

7123

6916

7212

EBT/ASSE

TS

All

Rotators

Retainers

0.00267

0.00267

0.00472

0.39265

0.24033

0.39265

0.04941

0.04982

0.04920

0.04172

0.04357

0.04113

0.03719

0.03520

0.03819

0.00267

0.00267

0.00651

0.39265

0.24033

0.39265

0.04954

0.05103

0.04849

0.04108

0.04274

0.04043

0.03997

0.03935

0.04043

0.00472

0.00664

0.00472

0.36160

0.16853

0.36160

0.04960

0.04803

0.05028

0.04271

0.04466

0.04209

0.03515

0.02935

0.03742

ACC/TA

(t-1)

AllRotators

Retainers

-0.25647

-0.14908-0.25647

0.21941

0.052520.21941

-0.02136

-0.02159-0.02123

-0.01875

-0.01966-0.01848

0.02262

0.019320.02415

-0.25647

-0.14908-0.25647

0.21941

0.052520.21941

-0.02538-

0.02396-0.02637

-0.02039

-0.02031-0.02047

0.02884

0.021760.03287

-0.07242

-0.06774-0.07242

0.06113

0.037140.06113

-0.01756

-0.01815-0.01730

-0.01676-

0.01748-0.01617

0.01451

0.014700.01444

Audit Fees

($000)

All

Rotators

Retainers

1

1

4

136

86

136

28.448625

24.490405

30.481928

23

20

26

17.004064

14.247447

17.929502

1

1

5

92

86

92

25.381703

23.203774

26.945799

21

19

22

15.537328

14.660682

15.974582

1

1

4

115

75

115

30.127389

25.81383

31.917455

26

21.5

27

16.956263

13.386577

17.970402

TACC/TA (t-1) is Total Accruals divided by lagged Total Assets

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TABLE 2

DESCRIPTIVE STATISTICS FOR DUMMY VARIABLES

LOCATION Audit Firm SIZE

Metro

(numbers, %

of all)

Non-Metro

(numbers, %

of all)

Big-N

(numbers,

% of all)

Non Big-N

(numbers,

% of all)

Rotators

N = 469

154

(32.84%)

315

(67.16%)

125

(26.65%)

344

(73.35%)

Retainers

N = 917

277

(30.21%)

640

(69.79%)

230

(25.08%)

687

(74.92%)

All

N = 1,386

431

(31.10%)

955

(68.90%)

355

(25.61%)

1,031

(74.39%)

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TABLE 3:

RESULTS FOR HYPOTHESIS 1

Variables Prediction Model 1 Model 2

Coef p-value1 Coef p-value1

ROTATION ? -0.008 0.011*** -0.008 0.002***

OCF (OCFWG & OCFNG) (-) -0.013 0.751 0.012 0.731

LEVERAGE (+) 0.020 0.509 -0.016 0.542

COUNSIZE ? -0.004 0.036** -0.005 0.007***

AFSIZE (-) 0.000 0.950 0.002 0.603

TENDER ? -0.008 0.000*** -0.011 0.000***

GROUP ? -0.002 0.510 -0.003 0.441

LOCATION (+) 0.005 0.149 -0.001 0.793

LNINDEXAF (-) -0.001 0.823 0.000 0.960

R 2 12.90% 20.90%

F statistic 5.04 6.38

p-value 0.000 0.000

1 p-values less than 0.010 *** , p-values less than 0.050** , p-values less than 0.100*

The models estimated were:

DMJ = β0 + β1ROTATION + β2OCF + β3LEVERAGE + β4COUNSIZE + β5AFSIZE + β6TENDER + β7 GROUP + β8 LOCATION + β9 LNINDEXAF (1)

DDD = β0 + β1ROTATION + β2OCF + β3LEVERAGE + β4COUNSIZE + β5AFSIZE + β6TENDER + β7 GROUP + β8 LOCATION + β9 LNINDEXAF (2)

Where:DMJ: total unexpected accruals in year t as the absolute value of the residual from MJ model

DDD: total unexpected accruals in year t as the absolute value of the residual from DD model

ROTATION: a dichotomous variable, coded 1 if the councils rotate, zero otherwise ;

OCF : Operating cash flow in year t scaled by lagged total assets (TAt-1);

LEVERAGE: the ratio of total lia bilities to total assets in Year t ;

COUNSIZE: the natural logarithm of total assets in Year t ;

AFSIZE : dummy variable, coded 1 if the audit firm is a Big-N audit firm, zero otherwise;

TENDER : dummy variable, coded 1 if the council‟s observation is in tender 1, zero otherwise;

GROUP: dummy variable, coded 1 if the council‟s observation is in group 1, zero otherwise;

LOCATION: dummy variable, coded 1 if the council is located within the Sydney Metropolitan region, zero otherwise;LNINDEXAF: the natural logarithm of indexed audit fees.

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TABLE 4:

RESULTS FOR TESTING HYPOTHESES 2 AND 3

Variable Prediction DA-MJ DA-DD DA-MJ DA-DDCo-efficient p-value Co-efficient p-value Co-efficient p-value Co-efficient p-value

ROTATORS RETAINERS(a) YEAR1 ? 0.003 0.109 0.002 0.246 0.008 0.000*** 0.005 0.000***

OCF - -0.069 0.039** -0.081 0.018** 0.095 0.004*** 0.065 0.004***

Leverage + 0.016 0.475 0.033 0.155 0.040 0.070* 0.015 0.179

Council Size ? -0.003 0.004*** -0.003 0.012** -0.002 0.055* -0.004 0.000***Audit Firm - 0.001 0.755 -0.001 0.679 -0.001 0.609 -0.001 0.429

Tender ? 0.003 0.012** 0.004 0.002*** 0.006 0.000*** 0.005 0.000***

Group ? -0.006 0.000*** -0.003 0.057* -0.003 0.215 0.001 0.422

Location + 0.002 0.392 -0.001 0.587 0.005 0.016** 0.002 0.189Audit Fee - 0.001 0.449 0.000 0.969 -0.002 0.332 0.003 0.048**

R 2 9.4% 9.5% 11.9% 17.7%

F-stat/p-value 4.1/0.000 4.16/0.000 9.55/0.000 14.96/0.000

(b) YEAR6 ? -0.002 0.226 -0.002 0.237 -0.001 0.516 0.000 0.648OCF - -0.026 0.000*** -0.211 0.000*** 0.238 0.000*** 0.099 0.000***

Leverage + 0.015 0.516 0.021 0.429 0.021 0.195 0.030 0.007***

Council Size ? -0.002 0.028** -0.003 0.004*** 0.000 0.637 -0.002 0.000***

Audit Firm - 0.000 0.775 -0.001 0.432 -0.002 0.101 -0.002 0.076*Tender ? 0.000 0.719 0.002 0.102 0.002 0.027** 0.002 0.004***

Group ? -0.005 0.001*** -0.003 0.108 -0.004 0.014** 0.000 0.808

Location + 0.001 0.566 -0.002 0.425 0.004 0.009*** 0.001 0.305

Audit Fee - 0.000 0.754 0.002 0.277 -0.002 0.215 0.001 0.290R 2 14.5% 12.00% 14.3% 14.5%

F-stat/p-value 6.71/0.000 5.13/0.000 11.74/0.000 11.72/0.000

(c) YEAR1-3 ? 0.003 0.029** 0.003 0.021** 0.004 0.006*** 0.003 0.000***

OCF - -0.065 0.028** -0.069 0.021** 0.107 0.000*** 0.083 0.000***Leverage + 0.023 0.253 0.018 0.408 0.040 0.030** 0.022 0.083*

Council Size ? -0.002 0.009*** -0.003 0.007*** -0.002 0.023** -0.004 0.000***Audit Firm - 0.000 0.929 -0.001 0.641 -0.001 0.401 -0.001 0.282

Tender ? 0.003 0.020*** 0.004 0.002*** 0.005 0.000*** 0.004 0.000***

Group ? -0.005 0.000*** -0.003 0.061* -0.003 0.106 0.001 0.399

Location + 0.003 0.091* -0.001 0.553 0.005 0.008*** 0.002 0.212

Audit Fee - 0.000 0.939 0.001 0.616 -0.001 0.442 0.003 0.032**

R2 8.20% 9.10% 10.30% 16.3%

F-stat/p-value 4.26/0.000 4.55/0.000 9.76/0.000 16.14/0.000

p-values less than 0.010 *** , p-values less than 0.050** , p-values less than 0.100*

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where:

DMJ: total unexpected accruals in year t as the absolute value of the residual from MJ model

DDD: total unexpected accruals in year t as the absolute value of the residual from DD modelYEAR1: dummy variable, coded 1 if it is the first year of the tenure, zero otherwise

YEAR6: dummy variable, coded 1 if it is the last year of the tenure, zero otherwise

YEAR1-3: dummy variable, coded 1 if it is the first three years of the tenure, zero otherwiseOCF: operating cash flow in year t scaled by lagged total assets

LEVERAGE: the ratio of total liabilities to total assets in year t

COUNCIL SIZE: the natural logarithm of total assets in year tAUDIT FIRM: dummy variable, coded 1 if the audit firm is a Big-N audit firm zero otherwise

TENDER: dummy variable, coded 1 if the council observation is in tender 1, zero otherwiseGROUP: dummy variable, coded 1 if the council‟s observation is in group 1, zero otherwise

LOCATION: dummy variable, coded 1 if the council is located within the Sydney Metropolitan region, zero otherwiseAUDIT FEE: natural logarithm of indexed audit fees

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TABLE 5 SUMMARY OF SIGNIFICANT RESULTS

Hypotheses Council auditor Periods for audit tenure Discretionary Accruals

(MJ model)

Discretionary Accruals

(DD model)

H1 Rotators - Retainers YEAR1 negative negative

H2(a) Rotated YEAR1 to middle years - -

H2(b) Rotated YEAR6 to middle years - -H2(c) Rotated YEAR1-3 to later years positive positive

H3(a) Retained YEAR1 to middle years positive positive

H3(b) Retained YEAR6 to middle years - -H3(c) Retained YEAR1-3 to later years positive positive

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