The Time Dependence of Audit Firm Alumni Effects: Evidence from Audit Committees

DOIhttp://doi.org/10.1111/ijau.12182
Published date01 March 2020
Date01 March 2020
ORIGINAL ARTICLE
The Time Dependence of Audit Firm Alumni Effects: Evidence
from Audit Committees
Matthias F. Baumann | Nicole V. S. Ratzinger-Sakel
University of Hamburg, Hamburg, Germany
Correspondence
Matthias F. Baumann, University of Hamburg,
Fakultät für Betriebswirtschaft,
Moorweidenstr. 18, 20148 Hamburg,
Germany.
Email: matthias.frank.baumann@uni-hamburg.
de
This article empirically examines the time dependence of audit quality and audit
fee effects resulting from the presence of audit firm alumni (AFA) on audit
committees (ACs) in the German setting. Following the European Union's audit
reform in 2014, the subject of this study is of particular importance, as European
regulators have strengthened the position of ACs, while simultaneously restricting
the presence of AFA on ACs. We find that the presence of AFA who have
recently left their former employer on ACs is associated with higher audit
quality, while we fail to find a significant effect on audit quality with regard to
AFA who have left audit firms a longer period of time ago. In addition, the pres-
ence of AFA on ACs does not seem to affect audit fees. To the best of our
knowledge, this study is the first to demonstrate time-dependent AFA effects
related to ACs.
KEYWORDS
Abnormal Accruals, Audit Committee, Audit Fees, Audit Firm Alumni, Audit Quality, Cooling-
off Periods, Corporate Governance, Earnings Benchmark Test, Germany, Time Dependence of
Alumni Effects
1|INTRODUCTION
Audit firms are not only known for their comparably high staff turn-
over but also for the considerable effort they make to keep in touch
with their former employees, for example, through alumni relations
programs that offer ways to maintain contacts with their alma mater
(Basioudis, 2007). Ex-auditors exhibit particularly high degrees of
knowledge on accounting and internal control systems (Naiker &
Sharma, 2009) and thus are natural candidates for influential financial
reporting positions within audited companies. Following this argu-
mentation, it is not surprising that the presence of audit firm alumni
(AFA)well-connected with their former employersin influential
positions in client companies has been common practice for several
decades (Basioudis, 2007; Imhoff, 1978).
However, regulators around the globe seem to be increasingly
anxious of situations in which AFA serve in monitoring and
executive positions concerned with the accounting system of an
entity that is audited by their alma mater. Following corporate
accounting scandals and the global financial crisis, regulators have
enacted rules partially restricting the appointment of AFA to such
positions. The concerns expressed by regulators seem to be shared
by users of financial statements, as prior literature has shown that
they perceive auditor independence to be jeopardized if ex-
auditors accept positions within companies that are audited by
their former employer (Koh & Mahathevan, 1993). Rules restricting
the employment of AFA explicitly refer to the recency of the rela-
tionship between AFA and audit firms. In the same vein, scholars
have argued that and investigated whether alumni effects are time-
dependent (e.g., Basioudis, 2007; Naiker & Sharma, 2009; Naiker,
Sharma, & Sharma, 2013).
1
However, despite the audit committee
(AC) being auditors' primary contact at the client during the audit
and AFA being excluded from serving on ACs based on cooling-off
Received: 30 January 2018 Revised: 14 November 2019 Accepted: 6 December 2019
DOI: 10.1111/ijau.12182
This is an open access article under the terms of the Creative Commons Attribution-NonCommercial-NoDerivs License, which permits use and distribution in any
medium, provided the original work is properly cited, the use is non-commercial and no modifications or adaptations are made.
© 2020 The Authors. International Journal of Auditing published by John Wiley & Sons Ltd
110 Int J Audit. 2020;24:110130.wileyonlinelibrary.com/journal/ijau
restrictions, prior research has so far not considered the potential
time dependence of AFA effects on audit characteristics such as
audit quality and audit fees. Thus, this study aims to investigate
the existence of time-dependent audit quality and audit fee effects
arising from AFA presence on ACs.
Following the European Union's reform of the audit market in
2014, it seems important to study the time dependence of effects
resulting from the presence of AFA on ACs in more detail.
European regulators have strengthened the position of ACs by
extending their competencies and emphasizing their importance in
interacting with the auditor, while simultaneously restricting the
presence of AFA on the ACs of client companies by imposing
cooling-off periods for such positions (European Union, 2014a,
2014b). In particular, a cooling-off period of 2 years is required
with regard to ACs of public-interest entities (European Union,
2014a). Some member states of the European Union even require
much longer cooling-off periods (e.g., 5 years) (FEE, 2016).
We run multivariate analyses on 477 firm-year observations
from the major German stock indices for the period 20122016 to
empirically examine the existence of time-dependent audit quality
and audit fee effects arising from AFA presence on ACs. Our find-
ings show that the presence of AFA who have recently left their
former employer on the AC is positively associated with audit qual-
ity. The observed effect is also economically significant, given that
companies that have AFA who have recently worked for the
company's current audit firm on their AC are 15.4% less likely to
report a small profit and have, on average, substantially
lower abnormal accruals than other companies. In contrast, audit
quality does not seem to be affected by the presence of AFA
who have left the audit firm a longer period of time ago. Our
results therefore suggest that a time dependence of alumni effects
on audit quality exists in the way that these effects fade over
time. However, we do not find the presence of AFA on the AC to
be significantly associated with the level of audit fees, implying
that there might be audit characteristics that are not affected
by AFA.
We contribute to the literature in the following ways. First, this
article is, to the best of our knowledge, the first to examine the time
dependence of audit quality and audit fee effects arising from AFA
presence on ACs. Second, in contrast to prior studies, which fail to
demonstrate a recency effect (Naiker et al., 2013; Naiker & Sharma,
2009), this article reports evidence of the existence of a time depen-
dence of AFA effects. Specifically, our results suggest that the time
between leaving the audit firm and joining a client's AC impacts audit
quality. Third, taking into account that the effect arising from the
presence of AFA who have recently left the audit firm is positive
(higher audit quality), this article is the first to provide evidence of
potential adverse consequences that might arise from cooling-off
rules restricting the presence of AFA on client companies' ACs.
Fourth, given that the presence of AFA on client companies' ACs is an
international phenomenon, our results are of general interest to regu-
lators, preparers and users of financial statements, and researchers in
other jurisdictions that have imposed cooling-off restrictions on AFA.
The remainder of this study is organized as follows. The next
section elaborates on the role of German ACs in the audit process.
The third section reviews relevant previous research and develops the
article's hypotheses. This is followed by sections outlining the
research design, data, and sample selection. The main results of the
study are presented in the sixth section. The seventh section presents
additional analyses and the eighth and final section provides the main
conclusions and limitations of this study.
2|THEROLEOFGERMANAUDIT
COMMITTEES IN THE AUDIT PROCESS
ACs play a crucial role in the audit process of German listed com-
panies. German ACs are responsible for a broad range of issues
related to the external audit and act as auditors' primary contact at
the client (Köhler, 2005). For instance, Köhler (2005) reports that
in many cases auditors attend every AC meeting and that responsi-
bilities related to the audit are perceived as being the top duties
of the AC.
In general, the influence AC members can exert on the audit
process is determined by the regulatory context in which ACs
operate. The manifold duties that German ACs shall fulfill are out-
lined in the German Stock Corporation Act (Aktiengesetz [AktG]
(2019)) and the German Corporate Governance Code (Deutscher
Corporate Governance Kodex [DCGK]).
2
With regard to the audit
process, the AktG and the DCGK state that the AC shall generally
address the audit(DCGK, section 5.3.2; AktG, section 107, para.
3, sentence 2). German law and regulations therefore assign a
comprehensive supervisory function to the AC, which, in turn,
allows the AC to take actions concerning all aspects related to the
audit and to influence auditors' work.
On the other hand, despite the general responsibility of ACs with
regard to the audit, particularly the DCGK also names more specific
ways in which ACs can influence the audit process. Specifically, the
DCGK states that the AC is responsible for monitoring auditor inde-
pendence and the effectiveness of the internal control system, the
audit fee agreement, and the determination of the key audit areas
(DCGK, section 5.3.2). While all of the mentioned responsibilities
should have a high relevance for the characteristics of the audit, such
as audit quality and audit fees, particularly the latter requires close
cooperation between AC members and auditors and gives AC mem-
bers a very direct opportunity to influence the audit process and its
outcomes. Further audit-related functions that are assigned to the AC
but not related to the execution of the audit per se are auditor selec-
tion, the issuance of the audit engagement, and the monitoring of
additional services rendered by the auditor (DCGK, sec. 5.3.2; AktG,
sec. 107, para. 3, sentence 2). Overall, given that the AC is involved in
a high number of material matters related to the audit process, AC
members are able to exert significant (positive or negative) influence
on audit characteristics. Potential ways in which AFA serving on ACs
might make use of this general possibility are considered in the next
section of this article.
BAUMANN AND RATZINGER-SAKEL 111

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