The Auditor-to-Client Revolving Door and Earnings Management

Abstract

The recent passing of the Sarbanes-Oxley Act of 2002 resulted in restrictions being placed on the so-called “revolving door,” where a company hires a senior financial reporting executive directly from its external audit firm. This legislative action, despite a lack of empirical research into the practice, reflects concerns about possible impairment of auditor independence through the hiring of personnel from the company's external auditor. Our study examines a sample of firms where financial reporting executives such as the CFO, VP-Finance, or Controller were hired by a public company directly from their external audit firm. Our results indicate that earnings management, in the form of increased accounting accruals, is no greater immediately before or after hiring in the companies engaging in this hiring practice compared to three separate control groups hiring individuals from other sources or retaining their incumbent financial reporting executives. We also find that changes in accruals surrounding the hiring of these former auditors is relatively stable over the 11-year period studied. Overall, our results with respect to changes in levels of reported accounting accruals generally do not support regulators' concerns of significantly impaired auditor independence in these hiring situations.

The hiring of accounting and finance officers from audit firms: how did the market react?

“…Similar to our study and consistent with the SOX restriction, Dowdell and Krishnan (2004) and Geiger et al (2005) focus specifically on revolving door appointments to senior corporate positions. Dowdell and Krishnan (2004) sample CFO appointments and their affiliated CFOs include not only former partners but also individuals who were employed at other ranks at audit firms.…”

“…While there is some evidence that revolving door appointments may have impaired the quality of audited financial statements (Menon & Williams, 2004;Lennox, 2005), the extant evidence is far from unanimous (Dowdell & Krishnan, 2004;Geiger, North & O'Connell, 2005;Geiger & North, 2006). If revolving door appointments did impair the credibility of financial reporting, shareholders may have viewed revolving door appointments unfavorably, in which case the market reaction may have been negative.…”

“…First, the study responds to a call by DeFond and Francis (2005) for further evidence on the impact of revolving door appointments. Prior studies investigate the effect of revolving door appointments on earnings management and on the issuance of going concern opinions (Dowdell & Krishnan, 2004;Geiger et al, 2005;Lennox, 2005;Menon & Williams, 2004), but the evidence from these studies is mixed and, as discussed later, the samples used in some studies do not directly address the types of appointments targeted by SOX. In contrast, we present evidence on the prevalence of the revolving door hires that are now banned by SOX and their impact on shareholder wealth and the quality of financial reporting.…”

“…They find that signed abnormal accruals are higher for revolving door hires but they find no significant differences in absolute abnormal accruals. Since the SOX restriction applies to all influential accounting and finance positions (CFO, Chief Accounting Officer, Controller, Vice-President of Finance), the sample in Geiger et al (2005) includes these other positions in addition to CFO. They find no significant difference in absolute accruals or non-operating accruals between the revolving door and the non-revolving door hiring companies.…”

Auditor Independence and Audit Quality

“…Geiger, North, and O'Connell (2005) indicate that the accruals of the firms that hire senior financial reporting personnel from external audit firms are not significantly higher than those of control firms (no-auditor, other audit firm, or no new-hire groups) for the years immediately before the hire, the year of hire, and three years surrounding the hire. Recent study by Geiger, Lennox, and North (2008) reports no significant evidence of lower financial reporting quality, proxied by accruals and likelihood to receive AAER, following the revolving door appointment.…”