U.S.

Audit Partner Rotations

Henry Laurion
henry_laurion@haas.berkeley.edu

Alastair Lawrence*
lawrence@haas.berkeley.edu

Haas School of Business

University of California at Berkeley
2220 Piedmont Avenue
Berkeley, CA 94720-1900

James Ryans
jryans@london.edu

London Business School

Regents Park
London, NW1 4SA
United Kingdom

June 2016

KEYWORDS: U.S. audit partner rotations; fresh look; restatements; valuation allowances and
reserves; write-downs; special items.

JEL CLASSIFICATION: M41; M42; M48.

DATA AVAILABILITY: Data are publicly available from sources identified in the article.

We have received valuable comments and suggestions from Clive Lennox (Editor), two anonymous reviewers, Hailey Ballew,
Nicole Bastian Johnson, Anne Beatty, Sam Bonsall, Zhan Bozanic, Agnes Cheng, Hans Christensen, Joshua Cutler, Angela
Davis, Richard Dietrich, Sunil Dutta, David Guenther, Wenli Huang, Bret Johnson, Yaniv Konchitchki, Miguel Minutti-Meza,
Alexander Nezlobin, James Ohlson, Kyle Peterson, Darren Roulstone, Terry Shevlin (2016 Interchange Discussant), Xiaoli
Tian, Andrew Van Buskirk, David Williams, Ryan Wilson, Kaishu Wu, Helen Zhang, Xiao-Jun Zhang, and seminar
participants at Hong Kong Polytechnic University, The Ohio State University, University of California at Berkeley, University
of Oregon, 2016 AAA Western Region Meeting Doctoral Student Faculty Interchange (Seattle), and audit partners at all the
Big 4 accounting firms. We thank Stephen Sloan for the helpful research assistance.
*Corresponding author.

Electronic copy available at: http://ssrn.com/abstract=2515586

 U.S. Audit Partner Rotations

ABSTRACT: We investigate the effects of audit partner rotation among U.S. publicly listed

firms, utilizing the fact that audit partners are periodically copied by name in public

correspondence between issuers and the SEC. Relative to non-rotation firms, we find no

evidence of a change in the frequency of misstatements following the partner rotation;

however, there is an increase in the frequency of restatement discoveries and announcements.

We also find an increase in deferred tax valuation allowances. Overall, the results provide some

evidence suggesting that U.S. partner rotations support a fresh look at the audit engagement.

Electronic copy available at: http://ssrn.com/abstract=2515586

 1. INTRODUCTION

In this study we investigate the effects of audit partner rotation among U.S. publicly

listed firms by means of the fact that audit partners are periodically copied by name in public

correspondence between issuers and the Securities and Exchange Commission (SEC). For over

35 years partner rotation has been a component of quality control processes for a vast majority

of the accounting firms that audit SEC registrants (SEC 2003). Audit partner rotation is

intended to maintain auditor independence and bring a fresh look to audit engagements, while

maintaining continuity and overall audit quality (e.g., SEC 2003). Such rotations have generally

reflected compromises in place of full audit firm rotations, which involve significantly greater

switching costs. Regulators state that partner rotation requirements must balance the need to

achieve a fresh look and independence against the need for the audit engagement team to be

composed of competent auditors. Consequently, there is growing interest in who should be

subject to rotation and how long a partner should remain on the engagement prior to rotating.

In 1978, the American Institute of Certified Public Accountants (AICPA) introduced

partner rotation with the requirement that the lead audit partner rotate off an audit engagement

of SEC registrants after seven years. Then, prior to returning, the partner must take a two-year

time out, also known as a cooling off period (AICPA 1978). The Sarbanes-Oxley Act of

2002 (SOX) further requires that both the lead partner and the concurring partner (reviewing

partner) rotate off the audit engagement of SEC registrants after five years (SOX 2002).

Furthermore, the SEC adopted rules in 2003, requiring a five-year time out period for both lead

and concurring partners (SEC 2003). Thus, under current U.S. standards, lead audit partners

must rotate off an audit engagement for an SEC registrant after five years and then sit out for

another five years before returning to the audit engagement.

Audit partner rotation addresses a concern that long-term relationships between audit

partners and clients can compromise partner objectivity and independence. Specifically,

1
partners are more likely to lose independence and acquiesce to client positions as they become

increasingly familiar with management (e.g., Bamber and Iyer 2007). Partners may also be

reluctant to realize restatements, as this can have a detrimental effect on compensation (e.g.,

Hennes, Leone, and Miller 2014). New partners may help counter the development of such

familiarity and bring a renewed sense of skepticism as well as additional insights and expertise

to the engagement. While incoming audit partners might be reluctant to call attention to a

fellow partners past mistakes, litigation risk will increase for incoming partners if they do not

correct errors and adjust unreasonable assumptions. There may also be costs to partner rotation,

including management influence on the selection of new partners (Cohen, Krishnamoorthy, and

Wright 2010). Additionally, the new partner may be less informed about the client and have

less industry expertise (Daugherty, Dickins, Hatfield, and Higgs 2012).

Examining the empirical effectiveness of U.S. partner rotation is difficult because audit

partner identities, and therefore rotations, are not disclosed in U.S. audit reports (PCAOB

2013). Nevertheless, the limited U.S. evidence generally indicates that partner rotation

decreases audit quality as a result of the loss of client-specific knowledge and industry

expertise. In international settings where audit partner identities are publicly disclosed (e.g.,

Australia, China, Germany, and Taiwan), studies have provided mixed evidence concerning the

effects of partner rotation (e.g., Carey and Simnett 2006; Chi and Huang 2005; Chen, Lin, and

Lin 2008; Chi, Huang, Liao, and Xie 2009; Gold, Lindscheid, Pott, and Watrin, 2012;

Azizkhani, Monroe, and Shailer 2012; Firth, Rui, and Wu 2012; Lennox, Wu, and Zhang

2014).

To identify partner rotations, we utilize SEC comment letters, which are publicly

disclosed correspondences between issuers and the SEC. SOX requires that the SECs Division

of Corporation Finance (DCF) review each issuers annual report and related filings at least

once every three years. In practice, reviews occur on average every two years (SEC 2015).

2
When issuers respond to the DCFs questions in comment letters, they often copy a variety of

parties in their response letters, including legal counsel, SEC staff, and audit partners.

Consequently, we identify a sample of partner rotations when different audit partners are

copied on comment letters issued in consecutive years and employ this approach to construct

our primary sample of 205 U.S. partner rotations at 189 SEC public companies from 2006 to

2014. 1

Bamber and Bamber (2009) emphasize that the effects of partner rotation are likely to

be modest, and in order to detect an economically material effect, should one exist, empirical

tests must be well-specified. Additionally, they note the importance of analyzing changes in

audit quality concurrent with partner rotations rather than tenure, and using sharper measures of

audit quality (rather than discretionary accruals and earnings response coefficients). In

accordance with their recommendation, we specify financial reporting measures that are likely

to be influenced by the incoming audit partner and conduct our tests in periods surrounding

partner rotations.

Our study examines the incidence of restatements (discoveries, announcements, and

misstatements), write-downs, and special items, as well as changes in valuation allowances and

reserves (hereinafter allowances) surrounding partner rotation. If the incoming partner

identifies errors or inconsistencies with Generally Accepted Accounting Principles (GAAP),

then the frequency of restatement discoveries and announcements should increase under the

new partner. Additionally, if the incoming partner provides a more thorough audit, then the

frequency of misstatements may decrease under the new partner. Moreover, a significant

requirement of an audit is skeptical analysis of management estimates, which will affect

impairments, special items, and accruals related to allowances. If an outgoing audit partner has

not required asset impairments or allowance increases when such measures are suggested by
1
We utilize consecutive years to mean either two years in a row or with a one-year gap in between.

3
GAAP, then an incoming partner, with greater independence and the ability to identify and

require disclosure, is more likely to require impairments or increases in allowances. Identifying

and disclosing financial reporting issues are the two key components of audit quality as defined

by DeAngelo (1981). Accordingly, we examine changes in the foregoing financial reporting

measures in an attempt to capture circumstances where the new audit partner both identifies

and requires disclosure of accounting issues to comply with GAAP.

We use a difference-in-differences research design to compare the financial reporting

measures for partner rotation firms before and after treatment against a control group of non-

rotating firms. The findings provide some evidence suggesting that partner rotation supports a

fresh look. Specifically, relative to non-rotation firms, we find that there is no change in the

frequency of misstatements (i.e., restated periods) following the partner rotation; however,

restatement discoveries and restatement announcements display relative increases of 4.6 and

3.8 percentage points, respectively. The restatement discoveries and announcements for partner

change firms primarily relate to related party or subsidiary issues, accounting for income taxes,

cash flow statement classification errors, and fixed asset impairment issues. Although, we find

that total allowances increase by 0.8 percent of assets following a partner change, this finding is

a weak result as it is primarily driven by the increase in the deferred tax asset valuation

allowance, not by other major allowances. Furthermore, although we find no evidence of

increases in write-downs and negative special items, we find some evidence of decreases in

positive special items following the partner rotation.

While this study is one of the first to directly examine U.S. partner rotations using

publicly available audit partner data, it has limitations. First, we are only able to observe

partner rotation (for treatment firms) and non-rotation (for control firms) when partner names

are disclosed in consecutive comment letter correspondences. As a result, we identify rotations

and non-rotations for 568 U.S. public firms, and this sample reflects firms that are larger and

4
more economically significant than average. Apart from firm size, we find that the main

fundamentals and industry composition of our sample are fairly similar to the Compustat

population. Second, several of our findings have marginal statistical significance which could

reflect the small available sample sizes or indicate that the effects of a partner rotation are fairly

modest.

Third, the periodic frequency of partner identification in our setting results in the

inability to identify whether a partner rotation is voluntary or mandatory, which raises concerns

as to whether the rotation was requested by the client due to a conflict or was a damage control

measure in response to issues raised in the comment letter or to an anticipated restatement. To

mitigate concerns that the comment letters resulted in the partner rotation, we examine all our

restatements to ensure that the restatement was not related to an issue raised in the SEC

comment letters. Additionally, we discussed the rate of voluntary rotations with audit partners

from all four Big 4 firms, who indicated that few partner rotations in the U.S. are voluntary,

noting that audit firms prefer to make five-year commitments because, for both the client and

the auditor, the change is disruptive to the audit. 2 When voluntary rotation does occur, the most

frequently cited reasons given were retirements, relocations, medical emergencies, and new

public-client responsibilities. Consistent with this reasoning, we find that the incidence of

rotation in our sample is 16.4 percent, which is close to the expected 20 percent if partner

rotations were to occur precisely every five years under the mandatory rotation provisions

specified in SOX. However, as we are unable to determine whether comment letters are issued

evenly throughout the audit partners tenure, 20 percent may not be the correct expected

mandatory rotation rate. Hence, despite the fact that rotations in our sample appear to be largely

mandatory, because we cannot conclusively determine whether this is the case, we cannot rule

out the possibility that some rotations occurred voluntarily as damage control measures.

2
These discussions are relevant for our study given that 91.2 percent of our sample has a Big 4 auditor.

5
 Fourth, we identify partner rotations when new audit partners are copied in comment

letter correspondence. If a firm also copies a prior partner, then we record a non-rotation, even

though a rotation could have taken place, leading to possible measurement error in our non-

rotation sample. This measurement error may be a reason why our observed partner rotation

rate is 16.4 percent instead of 20 percent under mandatory rotations, and will bias against our

results. We perform additional analyses to ensure our results hold in a clean subsample of non-

rotations.

Fifth, although restatement discoveries and announcements are generally seen as

improving financial reporting quality, increases in write-downs, negative special items, and

allowances reflect more conservative financial reporting. However, conservative financial

reporting does not necessarily better reflect the underlying business performance. For example,

firms can write down their assets or increase valuation allowances to better reflect economic

circumstances, or they may take such actions in order to be able to report better results in the

future. However, in our sample the increases in valuation allowances and decreases in positive

special items appear to be driven by the auditor and not the firm, suggesting that such changes

are consistent with DeAngelos (1981) conceptual definition of audit quality. Moreover, recent

research by Lennox, Wu, and Zhang (2015, Table 6) indicates that year-end audit adjustments

of Chinese audit firms result in significant reductions in pre-audit accruals, which is consistent

with our findings that auditors require more conservative financial reporting. Sixth, while our

use of comment letters permits us to determine lead audit partner rotations, the same cannot be

said for concurring audit partner rotations. Hence, a further limitation of our study is an

uncertainty as to whether our findings reflect the effects of lead partner rotations or the joint

effects of rotations of both lead and concurring partners.

Our contribution to the existing literature is to provide some evidence suggesting that

partner rotation permits a fresh look at U.S. audit engagements. Our study closely relates to that

6
of Lennox et al. (2014), who examine mandatory partner rotation in China, using proprietary

audit adjustment data to measure audit quality. Lennox et al. (2014) show that audit

adjustments increase in the year after mandatory partner rotation. 3 Our paper extends their

work to the U.S. setting, using publicly available data for both partner identification and audit

quality measures.

We believe that our study will inform the U.S. debate over audit firm rotation by

providing some evidence suggesting that (1) firm rotation is not the only means available to

provide fresh looks at audit engagements, and (2) the current fresh look mechanism has a

measurable effect. Our findings also support the PCAOBs recent rules requiring the disclosure

of audit partner names starting in 2017 (PCAOB 2015a). Disclosing partner identities would

allow financial statement users to identify partner rotation schedules and, in turn, anticipate

possible financial reporting effects.

2. BACKGROUND AND HYPOTHESES

Background

In the U.S., audit partner rotation is the primary quality assurance practice to encourage

auditor independence, transparency, and accountability. To further improve auditor

independence in the U.S., SOX decreased the period of mandatory partner rotation from seven

to five years (SOX, Section 203) and encouraged studies examining the impact of mandatory

audit firm rotation (SOX, Section 207). More recently, to improve the transparency and the

accountability of the audit process, the PCAOB will require audit engagement partners to

disclose their identities (PCAOB 2015a) and proposed that auditors provide 28 quality

indicators pertaining to audit staffing, process, and results (PCAOB 2015b).

3
Lennox et al. (2014) also find evidence of an increase in audit adjustments in the year prior to mandatory
rotation, suggesting that audit partners increase audit scrutiny when they expect their work to be reviewed by an
incoming partner.

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 Given the importance of partner rotation for supporting the independence of U.S.

auditors, the purpose of this study is to examine the empirical evidence of the rotation

mechanism's effectiveness. Although prior research identifies benefits of partner rotation (e.g.,

Bamber and Iyer 2007), noted drawbacks include the ability of management or the audit

committee to influence the selection of the new audit partner (e.g., Cohen et al. 2010; Beasley,

Carcello, Hermanson, and Neal 2009) as well as a decrease in partner expertise, because

incoming partners are less likely to have specific industry experience (e.g., Daugherty et al.

2012). Research also proposes that new partners spend less time on audit quality related

activities (e.g., Winn 2014).

There are only a few studies that examine the audit quality effects of partner rotations

for U.S. public companies. Manry, Mock, and Turner (2008) investigate audit partner tenure

and discretionary accruals using hand-collected audit records from a sample of 90 firms,

finding that discretionary accruals decline with partner tenure for small firms, but not for large

firms. Litt, Sharma, Simpson, and Tanyi (2014) use the fifth consecutive year after an audit

firm change to proxy for an audit partner change and find lower earnings quality following a

presumed partner rotation. Specifically, they observe increases in the propensity to meet or beat

earnings forecasts using discretionary accruals, and decreases in the propensity to issue going-

concern opinions following the presumed rotation.

An issue with both Litt et al. (2014) and Manry et al. (2008) is the use of accruals as the

measures of audit quality, which Bamber and Bamber (2009) find to be an unsatisfying proxy

for audit quality. One study that addresses this concern in the U.S. not-for-profit setting is

Fitzgerald, Omer, and Thompson (2015), who note an increase in the likelihood of reporting an

internal control deficiency during the second year after a partner rotation. While not looking at

audit quality per se, Bedard and Johnstone (2010) utilize a proprietary sample from a single

U.S. audit firm, and find that audit partners invest a significant amount of additional time

8
following partner rotation. Lennox et al. (2014) also move away from the use of accruals and

examine the effects of mandatory partner rotation using a proprietary database of audit

adjustments. They observe that audit quality increases in the years prior to and following

mandatory partner rotation.

The majority of empirical partner rotation studies use data from the following countries

where the identification of audit partners is required: Australia (e.g., Carey and Simnett 2006;

Fargher, Lee, and Mande 2008; Azizkhani et al. 2012), Taiwan (e.g., Chi and Huang 2005;

Chen et al. 2008; Chi et al. 2009), Germany (e.g., Gold et al. 2012), and China (e.g., Firth et al.

2012; Lennox et al. 2014). 4 These studies examine rotations, which range from the purely

voluntary (e.g., Carey and Simnett 2006; Chen et al. 2008) to those identified as mandatory

(Chi et al. 2009; Lennox et al. 2014). While these studies provide valuable insights into the role

of partner rotation, the applicability of such findings to the U.S. depends upon the extent that

the incentives of companies and auditors as well as institutional and political features in the

countries in question align with those in the U.S. 5

Overall, the international studies we cited provide conflicting results. For example, Chi

and Huang (2005) consider the association between audit firm and audit partner tenure in

Taiwan using discretionary accruals. They find that earnings quality appears to improve for

approximately five years, but then declines with further increases in tenure. However, Carey

and Simnett (2006) find that longer audit partner tenure is negatively associated with financial

reporting quality in a study of partner rotation, which utilizes cross-sectional Australian audit

partner tenure data from a single-year, 1995. Chen et al. (2008) find contradictory results in

4
Audit partner identification allows researchers and investors to observe changes in audit partners but the audit
partner signature can also induce reputational incentive effects on audit partner behavior, potentially confounding
inferences about partner rotation (e.g., Bamber and Iyer 2007). For example, Carcello and Li (2013) find evidence
of improved audit quality through a decline in earnings management after the introduction of engagement partner
identification in the United Kingdom.
5
For example, the institutional and political features of China are substantially different from those of the U.S.
Lennox, Wu, and Zhang (2015) note that in China, the government has significant influence over the economy and
there are weak legal protections for investors.

9
Taiwan, where longer tenure is associated with lower discretionary accruals. Interestingly, in

the same study, Chen et al. (2008) also note that over half of partner rotations result in the

partner rotating back to the client after a single year time-out period. Chi et al. (2009) consider

the first year of mandatory partner rotation in Taiwan (i.e., 2004) and find only weak evidence

of lower quality financial reporting. Azizkhani et al. (2012) study the relation between audit

partner tenure, rotation, and the cost of capital, finding that partner rotation is associated with a

higher cost of capital. Lastly, Lennox et al. (2014), using a proprietary sample of audit

adjustments in China, find evidence that mandatory rotation is associated with higher audit

quality in the years before and after mandatory rotation. They also observe that voluntary

rotation is less likely when clients have financial reporting problems. Hence, approximately

half of the aforementioned studies find that partner rotation increases audit quality, and the

other half find a decrease.

Hypotheses

Audit quality has been defined as the auditors ability to (1) discover errors or breaches

in the accounting system, and (2) withstand client pressures to disclose selectively in the event

a breach is discovered (DeAngelo 1981, p. 115). Partner rotation may affect audit quality as a

consequence of changes in both expertise and independence. With respect to expertise, a

partner rotation may result in the loss of significant industry- and firm-specific knowledge,

favoring the argument for longer partner tenure. On the other hand, there are benefits to

rotation: a long-tenured partner may become complacent and provide less thorough audits,

because repeated interactions with management can lead to less critical reviews. Furthermore, a

new partner may bring a fresh look to the engagement, along with new knowledge and

techniques. With respect to independence, it is assumed that an incoming partner will have a

more distant relationship with client personnel and may be more willing to challenge

management estimates and assertions. However, a possible disadvantage in this case is that a

10
new partner's limited industry- and firm-specific knowledge may lead to reticence in exercising

independence and challenging management estimates, especially during the early years of their

involvement. Given these conflicting factors, if the partner rotation provides additional

independence and the fresh look that the policy is designed to achieve, then audit quality on

average should increase.

We agree with the suggestion of Bamber and Bamber (2009) that empirical tests must

be well-specified in order to provide valid inferences because the effects of audit rotation may

be modest. Our aim in this study is to apply DeAngelos (1981) concept of audit quality, and to

accomplish this we move beyond the use of discretionary accruals and earnings response

coefficients through an examination of changes in financial reporting measures that new audit

partners are likely to influence. First, we examine the incidence of restatements (e.g., Palmrose,

Richardson, and Scholz 2004; Hribar and Jenkins 2004; Kinney, Palmrose, and Scholz 2004,

Liu, Raghunandan, and Rama 2009). Hennes et al. (2014) find that audit firms are more likely

to be dismissed after restatements. If audit partners face employment-related penalties for

revealing a restatement, then the outgoing partner has incentives to delay the detection and

announcement of a restatement. If the new audit partner identifies and corrects GAAP errors

and inconsistences, and is able to attribute the restatement to the prior audit partners tenure,

then the incidence of restatement discoveries and announcements should increase following the

partner rotation, providing possible insights into the effect of the fresh look. Moreover, if the

incoming partner provides a more thorough audit than the previous partner and improves the

financial reporting processes of the client, then the frequency of misstatements may decrease

under the new partner.

Second, we examine the incidence of write-downs and special items surrounding the

partner rotation. Managers can exercise discretion to delay write-downs (e.g., Ramanna and

Watts 2012, Lawrence, Sloan, and Sun 2013) and record special items (e.g., McVay 2006).

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Hence, an important function of the auditor is to assess whether the firms assets are impaired,

or if charges need to be accrued. In turn, examining the frequency of write-downs and special

items following auditor rotations may also indicate circumstances where the new audit partner

identifies and requires corrections of GAAP errors and inconsistences that were overlooked by

the prior partner. Third, we examine the changes in allowances following partner rotation.

Disclosure of balances of and changes in allowances are required in the 10-K, either in a

Schedule II or in the notes to the financial statements. One example of a valuation allowance

and reserve account is the allowance for doubtful accounts. For this allowance, management

estimates are used to determine the opening and closing balances, the bad debt expense during

the period (increasing the allowance), and write-offs for uncollectible debts (reducing the

allowance). Cassell, Myers, and Seidel (2015) argue that companies will use allowances to

manage earnings if the probability of detection is sufficiently low. Given the significant amount

of discretion inherent in determining allowances, and the important effect that these accounts

have on the financial statements, auditors spend considerable effort assessing their

reasonableness and accuracy. Therefore, if partner rotations do, in fact, provide a fresh look at

the audit engagement, we expect to see increases, or fewer decreases, in allowances, following

the partner rotation.

Endogenous partner rotations are a concern in our setting because we cannot observe

whether a partner rotation is mandatory or voluntary. Partner rotation may cause the observed

financial reporting measure to change, or, on the other hand, the audit partner may be rotated

out as a result of changes in these measures. For example, if a restatement prompts the partner

rotation, then the restatement would have occurred prior to rotation. In this case, post-rotation

restatements will be exogenous. We review each restatement, and verify that none are

prompted by SEC comment letter reviews (i.e., Cheng, Gao, Lawrence, and Smith 2014).

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 Because management has overall responsibility for the preparation of financial

statements and the departing audit partner still has a professional duty to fulfill, the anticipated

partner rotation is unlikely to cause the pre-rotation financials to be misstated. If anything, the

departing partner may conduct a more thorough audit during the year prior to rotation if she has

concerns that the incoming partner will review her work and report sub-standard behavior

within her firm (Lennox et al. 2014). Consequently, we could observe either no changes to the

examined financial reporting measures (restatements, write-downs, special items, and

allowances), or a combination of changes in these measures prior to partner rotation and after

partner rotation.

Lennox et al. (2014), in their examination of the actual audit adjustments of Chinese

auditors surrounding mandatory partner rotations, provide evidence suggesting that audit

quality increases in the year immediately preceding and following the mandatory partner

rotation. Consistent with the foregoing inferences from Lennox et al. (2014), if the proposed

benefits of partner rotation exceed the costs, the new partner may find errors or inconsistencies

with the financial reporting practices of the client and require the client to disclose such errors

or inconsistencies. In turn, given the measures we examine, following partner rotations we

should see increases in restatement discoveries and announcements, write-downs and special

items, and allowances, and decreases in misstatements. Hence, our three hypotheses are as

follows (stated in alternative form):

H1: Audit partner rotation is associated with an increase in financial statement

restatement discoveries and announcements, and a decrease in misstatements.

H2: Audit partner rotation is associated with an increase in write-downs and

negative special items, and a decrease in positive special items.

H3: Audit partner rotation is associated with an increase in valuation allowances

and reserves.

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 3. RESEARCH DESIGN AND DATA

Research Design

We identify audit partner rotations utilizing SEC comment letter correspondences for

issuers who have received comment letter reviews in two consecutive years that copy different

audit partners for each of those years. To ensure that the results of the study do not simply

reflect the effects of the two consecutive comment letter reviews, we implement a difference-

in-differences strategy, matching partner rotation firms to control firms that have comment

letter reviews in consecutive years, but copy the same audit partner. We match treatment and

control firms by year, Fama-French 49 industry codes, and market value (closest).

To study restatements, we estimate a difference-in-differences model, using logit and

conditional logit specifications, where the matched pair groupings serve as the conditioning

variable (see Cram, Karan, and Stuart 2009). We estimate the following restatements models:

I(Restatement discoveryi,t) = 0 + 1 TREATi,t + 2 POSTi,t + 3 TREATi,t * POSTi,t (1)

+ CONTROLS + SEC office fixed effects + i,t ,

I(Restatement announcementi,t) = 0 + 1 TREATi,t + 2 POSTi,t + 3 TREATi,t * (2)

POSTi,t + CONTROLS + SEC office fixed effects + i,t ,

I(Misstatementi,t) = 0 + 1 TREATi,t + 2 POSTi,t + 3 TREATi,t * POSTi,t + (3)

CONTROLS + SEC office fixed effects + i,t ,

where I(Restatement discoveryi,t) equals 1 for firm i in year t, if the firm discovers a

restatement after the annual report is filed for year t-1 and on or before the date the annual

report is filed for year t, and 0 otherwise, as depicted in Figure 1. We read each restatement

discussion during our sample period to determine when the issue was discovered by the

company. If the discovery date is not disclosed, we assume that the announcement date is also

the discovery date. If the company only reports the financial reporting period that restatement

14
was discovered and not a specific date, we assume the discovery was made on the first day of

the period. I(Restatement announcementi,t) equals 1 for firm i in year t, if the firm announces

a restatement after the annual report is filed for year t-1 and on or before the date the annual

report is filed for year t, and 0 otherwise, again as depicted in Figure 1. The announcement

date is available from Audit Analytics. I(Misstatementi,t) equals 1 if a firm i restates any

portion of fiscal year t, and 0 otherwise. The misstatement period is also available from Audit

Analytics. POSTi,t equals 1 if the year corresponds to the first or second year following the

partner rotation (Year 0 or Year 1), but 0 if the year corresponds to the first or second year

prior to the partner rotation (Year -1 or Year -2); and TREATi,t equals 1 if the firm is a partner

rotation firm, but 0 if the firm is a control firm. We include the following set of control

variables, which Dechow, Ge, Larson, and Sloan (2011) show predict restatements: Total

accruals, Receivables, Inventory, percentage of Soft assets, Leverage, an indicator for

securities issuance (I(Issuance)), Return on assets, Return on assets, an indicator for having a

Big 4 auditor (I(Big 4 auditor)), Age, Book to market, and the natural logarithm of Market

value. Detailed variable definitions are presented in Appendix A. We also include fixed effects

for the SEC office issuing the comment letter. For the restatement discovery and announcement

regressions, a positive and significant coefficient for 3 is consistent with H1, that partner

rotation is associated with an increase in the discovery and announcement of financial

statement restatements, which suggests that new audit partners catch errors in prior financial

statements that were not caught by the previous audit partner. For the misstatement regressions,

a negative and significant coefficient for 3 is consistent with H1, that the incoming partner

provides a more thorough audit than the outgoing partner.

To examine the effect of audit partner rotations on the incidence of write-downs and

special items, we estimate the following models using logit and conditional logit specifications:

15
 I(Write-downi,t) = 0 + 1 TREATi,t + 2 POSTi,t + 3 TREATi,t * POSTi,t + (4)

CONTROLS + i,t ,

I(Negative special itemi,t) = 0 + 1 TREATi,t + 2 POSTi,t + 3 TREATi,t * POSTi,t + (5)

CONTROLS + i,t ,

I(Positive special itemi,t) = 0 + 1 TREATi,t + 2 POSTi,t + 3 TREATi,t * POSTi,t + (6)

CONTROLS + i,t ,

where I(Write-downi,t) equals 1 if firm i has a write-down in year t, but 0 otherwise;

I(Negative special itemi,t) equals 1 if firm i has a negative special item (expense) in year t, but

0 otherwise; and I(Positive special itemi,t) equals 1 if firm i has a positive special item

(income) in year t, but 0 otherwise. Because write-downs and special items are relatively

infrequent events, yet they may have extreme values, we estimate these models using indicator

variables for the dependent variables to prevent outliers from influencing the results. POSTi,t

and TREATi,t are defined as for Equation (1). We control the following documented

determinants of write-downs and special items: the level of Intangibles, an indicator if Book to

market is greater than one (I(Book to market > 1)), Operating income, and the natural logarithm

of Market value (e.g., Lawrence et al. 2013). Consistent with H2, we expect 3 to be: positive

for Equation (4), if partner rotation is associated with an increase in write-downs of impaired

assets; positive for Equation (5), if partner rotation is associated with an increase in negative

special items; and negative for Equation (6), if partner rotation is associated with a reduction in

positive special items.

To examine the effect of audit partner rotations on changes in allowances, we

implement the following OLS regression model:

Dependent variablei,t = 0 + 1 TREATi,t + 2 POSTi,t + 3 TREATi,t * POSTi,t + (7)

CONTROLS + Matched pair fixed effects + i,t ,

16
where Dependent variablei,t refers to one of the following values for firm i in year t: Total

allowance, Allowance for doubtful accounts, Inventory allowance, Deferred tax asset

allowance, Sales returns allowance, Loan loss allowance, and Other allowance. More

specifically, Total allowance is the sum of all allowance accounts for each firm-year;

Allowance for doubtful accounts is the estimate of uncollectible accounts receivable; Inventory

allowance is an estimate of inventory obsolescence; Deferred tax asset allowance is an

estimate of future tax benefits that will not be realized; Sales returns allowance is an estimate

of current period sales that will be refunded; Loan loss allowance is an estimate of loans that

will not be repaid; and Other allowance is the sum of all valuation allowances or reserve

accounts that did not fit into one of the above sub-categories. Examples of other allowances and

reserve accounts include estimated future product warranty costs, estimated asset impairment

reserves, estimated future workers compensation costs, and many others. Allowance variables

are scaled by the sum of the ending balances of all allowances and total assets. POSTi,t and

TREATi,t are defined above in Equation (1). We control for the following factors that are likely

to influence changes in these allowance accounts but are unrelated to the audit rotation: Time in

receivables, Time in inventory, Return on assets, an indicator for a loss (I(Loss)), Book to

market, the natural logarithm of Sales, the natural logarithm of Cost of goods sold, and the

natural logarithm of Market value. A positive and significant coefficient on 3 is consistent

with H3's conjecture that audit partner rotation is associated with an increase in allowances.

Data

We utilize the Audit Analytics Comment Letter database to identify SEC comment

letter correspondences spanning the decade from 2004 to 2014. Employing audit fee data from

Audit Analytics, we identify 49 audit firms with market share ranked in the top ten from 2000

to 2014. We then search the Audit Analytics Comment Letter Database field

WEB_GRP_PPL_COPIED, which contains a parsed list of the names and organizations of

17
those copied on the correspondence. Searching for partner names associated with the 49 audit

firms, we identify 1,940 client firms that copy their audit partner by name in correspondence

with the SEC.

The date of the comment letter response is taken as the service date for the partner

copied, following which we utilize the Compustat annual file to assign fiscal years to service

dates. For every firm-year with at least one service date, we create a list of all names copied in

comment letter responses during that year. We assume these are the individuals serving the

company for that fiscal year (providing, for example, quarterly reviews, internal control

evaluations, and year-end audits). Conversations with auditors confirm that clients tend to cc

the current audit partner who will be responsible for the subsequent 10-K audit opinion.

In some cases there are multiple names from the same audit firm copied in one letter. In

untabulated analysis, we find that 56 percent of comment letters in our sample contain more

than one name. In order to determine a partner rotation, we require that for any given client the

list of auditor names in the pre-rotation year does not share any names with the post-rotation

year, and that all names belong to the same accounting firm. Year 0 is defined as the year in

which a new partners name is observed in a firm's correspondence with the SEC. We identify

142 partner rotations in which the outgoing partner was named in Year -1 and 136 partner

rotations in which there is no comment letter in Year -1 and the outgoing partner is named in

Year -2. For the latter type of partner rotation, we assume the departing partners final year is

Year -1 and the new partners first year is Year 0. 6 To mitigate the effect of possible voluntary

rotations, we check that there are no other rotations observed within each four-year period.

Partner non-rotations are defined as firms for which the same partner name appears in the pre-

6
When we assume the departing partners final year is Year -2 and the new partner first year is Year -1, the
studys main inferences are generally similar, albeit stronger for the restatement analyses, insignificant for the
write-down and special-items analyses, and weaker for the allowance analyses. For the allowance analyses, we
find that results in Table 6, Panel A become insignificant (p > 0.10) but remain significant (p < 0.05) in Panels B
and C.

18
and post-period. Appendix B provides an example of how we use the comment letter

correspondence to identify audit partner rotations, and Figure 1 illustrates the specific timing of

this process. In our final sample, we manually check a subsample of 50 identified names, using

Google and LinkedIn to confirm that the named individuals are indeed audit partners.

We include two years of data before the partner rotation and two years after the partner

rotation, where available, for each partner rotation event. We match each partner rotation firm

to a non-rotation control firm in Year 0, which must be the same fiscal year for both the partner

rotation firm and the control firm. We observe non-rotations when the same audit partner is

copied in either Year -2 or Year -1, and in Year 0. 7 We further require that the control firm not

have any other observed rotations in the four-year window from Year -2 to Year 1. A valid

control must be in the same Fama-French 49 industry group as the rotation firm. Both the

rotation firm and the control are required to have all variables available in Years -1 and 0 at a

minimum, and where additional years are available, the rotation and control firm-year

observations must match. For each rotation firm, we select the available control firm closest in

market value in Year 0 as the matched control.

We obtain restatement data from the Audit Analytics Non-Reliance Restatements

database, which includes Form 8-K, item 4.02 disclosures, as well as other filings that contain

variations of the word restate, including Forms 8-K, 8-K/A, 10-K, 10- Q, 10-Q/A, 10-K/A,

which have been confirmed by examination to involve a restatement of previously issued

financial statements. Audit Analytics excludes restatements relating to retrospective revisions

for comparative purposes, retrospective application of accounting principles, and changes in

presentation as a result of mergers. We read the disclosure of each restatement in our sample to

7
In 30 percent non-rotation observations, there are multiple names copied on the comment letters with one name
that stays the same, but also one name that changes from the pre-period to the post-period. For example, Kate and
John may be copied in the pre-period and Kate and Jill are copied in the post-period. This observation may, in fact,
be a rotation event, with John as the outgoing partner and Jill as the incoming audit partner. We perform an
additional analysis and ensure our main results are not sensitive to these observations.

19
determine when the accounting issue was discovered by the company. The restatement

announcement date and the misstatement period are available from Audit Analytics.

We obtain write-down and special item data from the Compustat annual file; see

Appendix A for detailed variable definitions. Also, we hand-collect allowance account activity

from companies financial statements. Our initial source of data for allowance account activity

is Schedule II Valuation and Qualifying Accounts, which includes a roll-forward of all

material valuation allowance and reserve accounts 43 percent of firms in our sample report

this schedule. Firms that do not report this schedule are required to include this information, if

material, in the footnotes to their financial statements. Consequently, we search each annual

report manually using a list of common allowance account terms to identify and collect

activities and balances in these accounts. The majority of the 57 percent of firms that do not

report a Schedule II do report the ending balance of at least one allowance account, although

many do not report the annual activity despite the requirement to do so. As such, the sample

sizes are insufficient for testing activity in allowance accounts, although they are sufficient for

examination of the changes in ending balances.

4. RESULTS

Sample and Descriptive Statistics

Table 1, Panel A provides details about our sample. We begin with 11,710 firms

(75,505 firm-years) in Compustat with required variables available from 2004 to 2014. Because

we use comment letters to identify audit partners and, in turn, partner rotations, our sample is

limited to those firms that have received comment letters from the SEC in consecutive years.

We find that 8,940 firms (76.4 percent of Compustat firms) have received a comment letter at

least once during our sample period and 6,626 firms (56.6 percent) received comment letters

for two of three years. Panel A demonstrates that limiting our sample to firms that copy the

audit partner on comment letter correspondences results in the greatest sample attrition.
20
Specifically, we find that 568 firms (1,240 firm-years) copy the audit partner by name on

comment letter correspondences for two of three years, which means that we can identify

rotations and non-rotations for 4.9 percent of Compustat firms. After the application of these

restrictions, we identify 278 rotations across 241 firms (2.1 percent of Compustat firms) and

962 non-rotations across 507 firms (4.3 percent of Compustat firms). The final restatement,

write-down and special item, and valuation allowance and reserve samples contain 198, 205,

and 192 rotation observations, respectively, when further restricting the samples to those

observations that have suitable matches and available control variables.

Table 1, Panel B illustrates that the industry composition of our partner rotation sample

and the Compustat population are similar. Trading, Banking, and Computer Software are the

three most frequent industries in both our sample and in the Compustat population. Our sample

lacks representation from some of the smaller industries. For example, Restaurants, Hotels,

Motels is the largest industry missing from our sample, which represents 1.2 percent of

Compustat firm-years.

Table 2 provides means and medians for all variables in our partner rotation sample, the

matched non-rotation sample, and the 2004 2014 Compustat population. Panel A presents the

primary variables and sample used in the restatements analysis, Panel B presents the primary

variables and sample for the write-downs and special items analysis, and Panel C gives the

primary variables and sample for the allowances analysis. In Panel A, the incidence of

restatement discovery is lower for partner rotation firms than non-rotation firms: specifically,

6.8 percent and 8.0 percent of rotation and non-rotation firm-years, respectively, have

restatements discovered during the year. The incidence of restatement announcement is also

lower for partner rotation firms than non-rotation firms: specifically, 6.8 percent and 8.3

percent of rotation and non-rotation firm-years, respectively, have restatements announced

during the year, values comparable to the to the overall Compustat population incidence of 6.6

21
percent. The incidence of a misstatement is fairly similar between partner rotation and non-

rotation firm years, at 14.8 and 12.8 percent, respectively, values comparable to the overall

Compustat population incidence of 13.8 percent. The control variables are similar across the

rotation and non-rotation firms, with the exception of the Leverage ratios, Return-on-assets,

and Market value. The Leverage ratio is lower for partner rotation firm-years, with a mean

(median) value of 0.928 (0.405), compared to 1.338 (0.476) for non-rotation firm-years. Return

on assets is higher for partner rotation firm-years, with a mean (median) value of 0.035 (0.038),

versus 0.004 (0.024) for non-rotation firm-years. Market value is higher for partner rotation

firm-years with a mean (median) value, in millions, of $12,733 ($2,752) versus $6,380 ($1,872)

for non-rotation firm-years. Overall, rotation and non-rotation firms are fairly similar to the

overall Compustat population, although rotation and non-rotation firms are larger and,

consequently, have a higher frequency of Big 4 auditors. This size differential corresponds to

the findings of Cassell, Dreher, and Myers (2013) and Dechow, Lawrence, and Ryans (2016)

that larger firms are more likely to receive comment letters, due to the reporting complexity of

larger firms and as well as the fact that the SEC aims to conduct more frequent examinations of

economically significant firms. 8,9

In Table 2, Panel B the incidence of write-downs and special items is similar for

rotation and non-rotation firms: 26.0 percent and 23.1 percent of firm-years, respectively.

Likewise, the incidence of negative special items is 55.0 percent and 56.5 percent of firm-years

for rotation and non-rotation firms, respectively; and the incidence of positive special items is

8
In untabulated analyses, we find that audit partners are more likely to be copied on comment letters for larger
firms, for firms that have Big 4 auditors, if it is the firms first publicly disclosed SEC comment letter
conversation, and when the comment letter review raises questions about revenue recognition or includes more
rounds. Characteristics such as firm valuation multiples, profitability, growth rates, and leverage do not explain
whether the audit partner is copied.
9
In untabulated analysis, we find that many of the firms in our sample are members of the S&P 500 (e.g., Pfizer,
Bank of America, Cisco Systems, Amazon, etc.). The partner rotation sample includes some large foreign issuers
that would not have been required to rotate partners until 2009 due to SEC rule 33-8183 (SEC 2003). We re-run
our analyses excluding those rotations in foreign firm-years prior to 2009 and find results similar to those
presented in our main analyses.

22
17.3 percent and 18.3 percent of firm-years for rotation and non-rotation firms, respectively.

Both rotation and non-rotation firms have a higher incidence of write-downs, negative special

items, and positive special items than the 19.1 percent, 44.1 percent, and 14.8 percent of firm-

years observed, respectively, for the Compustat population. The incidence of Book to market

greater than one and the fraction of Intangibles to total assets are similar for rotation and non-

rotation firms. The incidence of Book to market greater than one is 16.1 percent and 17.9

percent of firm-years for rotation and non-rotation firms, respectively, and the mean (median)

values of Intangibles to total assets are 0.159 (0.067) and 0.183 (0.051) for rotation and non-

rotation firm-years, respectively. While the incidence of firm-years with Book to market greater

than one for the Compustat population of 16.9 percent is similar to that of rotation and non-

rotation firm-years, the mean (median) value of Intangibles to total assets of 0.128 (0.030) for

the Compustat population is lower than the corresponding values for rotation and non-rotation

firm-years.

In Table 2, Panel C the total amount of allowances is lower for rotation than non-

rotation firms. Specifically, the mean (median) value of Total allowance is 2.434 (0.702)

percent of assets for rotation firm and 3.748 (1.165) percent of assets for non-rotation firms.

Because the valuation allowance and reserve data for our sample were hand collected, we are

unable to report comparable statistics for the Compustat population. Many of the individual

allowances are similar for rotation and non-rotation firms; however, the Inventory allowance

and the Deferred tax asset allowance are lower for rotation than for non-rotation firms. In

particular, the mean (median) Inventory allowance is 0.059 (0) percent of assets for partner

rotation firm-years and 0.161 (0) percent of assets for non-rotation firm-years, values which

correspond to the Time in inventory figures of 0.513 (0.075) and 1.304 (0.082) for partner

rotation and non-rotation firm-years, respectively. The mean (median) Deferred tax asset

allowance is 1.470 (0) percent of assets for partner rotation firm-years and 2.842 (0.006)

23
percent of assets for non-rotation firm-years, which are partially explained by the Return on

assets values of 0.036 (0.035) and 0.014 (0.025) for rotation and non-rotation firm-years,

respectively.

In Table 3, we provide the mean values of our financial reporting measures,

conditioning on partner rotation firms (TREAT = 1) and non-rotation firms (TREAT = 0) during

the pre-rotation (POST = 0) and post-rotation periods (POST = 1). I(Restatement discovery) for

partner rotation firms is 6.77 percent in the pre-rotation period and 6.81 percent in the post-

rotation period, representing an insignificant increase. However, I(Restatement discovery) for

non-rotation firms decreases from 11.20 percent to 4.63 percent on average over the sample

period. This result is consistent with H1, as the partner rotation firms have relatively more

restatements discovered in the post period than the non-rotation firms. I(Restatement

announcement) for partner rotation firms is 6.25 percent in the pre-rotation period and 7.36

percent in the post-rotation period, representing an increase of 1.11 percentage points.

However, I(Restatement announcement) for non-rotation firms decreases from 10.68 percent to

5.72 percent on average over the sample period. This result is also consistent with H1, as the

partner rotation firms have relatively more restatements announced in the post period than the

non-rotation firms. The incidence of misstatements, however, is relatively similar for both

partner rotation firms and non-rotation firms in the pre- and post-rotation periods.

I(Misstatement) is 15.89 percent for both partner rotation and non-rotation firms in the pre-

rotation period, dropping to 13.62 percent for partner rotation firms and 9.54 percent for non-

rotation firms in the post rotation period.

Inconsistent with H2, I(Write-down) for partner rotation firms decreases from 27.65

percent to 24.35 percent from the pre- to post-rotation periods. The decrease in I(Write-down)

for non-rotation firms is slightly smaller, going from 24.44 percent in the pre-rotation period to

21.73 percent in the post-rotation period. While I(Negative special item) for partner rotation

24
firms increases from 53.33 to 56.81 percent from the pre-rotation period to the post-rotation

periods, in agreement with H2, there is no change in I(Positive special item) for partner rotation

firms. Interestingly, we observe a sharp decrease in I(Negative special item) and a sharp

increase in I(Positive special item) for non-rotation firms, which was not anticipated. One

possible explanation is that the partners of the non-rotation firms, who we presume are in the

first, second, or third year of service to their respective clients, are more likely to require

conservative special item charges in the first half of their terms (i.e., the pre-rotation period).

Finally, consistent with H3, the Total allowance for partner rotation firms increases

from 2.14 percent of total assets in the pre-rotation period to 2.75 percent in the post-rotation

period, while across the same periods the value for non-rotation firms decreases from 3.85 to

3.64 percent. The two allowances that provide the greatest contribution to the Total allowance

are the Deferred tax asset allowance and Other allowance. Across the pre- to post-rotation

periods, the mean Deferred tax asset allowance increases from 1.22 percent of total assets to

1.74 percent for partner rotation firms, while decreasing from 2.98 percent to 2.69 percent for

non-rotation firms. The mean Other allowance increases from 0.12 percent of total assets pre-

rotation to 0.23 percent post-rotation, whereas non-rotation firms see only a slight increase

from 0.14 to 0.16 percent of total assets.

Restatements Analysis

Figure 2, Panel A, which plots the yearly restatement discovery rates for partner

rotation firms and non-rotation firms during the pre-rotation years (Years -2 and -1) and post-

rotation years (Years 0 and 1), confirms the inferences from Table 3 that, relative to non-

rotation firms, I(Restatement discovery) for partner rotation firms does not decline as much as it

does for non-rotation firms, indicating a relative increase in restatement discoveries post-

rotation. Hence, the significant increases in I(Restatement discovery) for partner rotation firms

relative to non-rotation firms following the rotation suggest that the new audit partner is

25
associated with a higher level of restatement discoveries. Panel B, which plots the yearly

restatement announcement rates for partner rotation firms and non-rotation firms during the

pre-rotation years (Years -2 and -1) and post-rotation years (Years 0 and 1), confirms the

inferences from Table 3 that I(Restatement announcement) for partner rotation firms increases

subsequent to partner rotation, while at the same time as the incidence of restatement

announcements decreases for non-rotation firms. The decrease in restatement discoveries and

announcements for the non-rotation firms reflects the decreasing trend in restatement

discoveries and announcements for the Compustat population over our sample period.

Moreover, the reduction in the restatement discovery and announcement frequencies for the

non-rotation firms is also likely due to the fact that these firms will on average have just

experienced a partner rotation in the pre-period and hence, have higher restatement discovery

and announcement frequencies in the pre-period relative to the post-period due to the partner

rotation. Finally, in Panel C, I(Misstatement) declines for both groups of firms, though the

decline is not as pronounced for the partner rotation firms. Hence, while there is a relatively

similar trend in misstated periods for the two groups of firms, there are relatively higher levels

of restatement discovery and announcement for the partner rotation firms, suggesting that the

new audit partner is associated with a higher level of restatement discoveries and disclosures.

Table 4 presents regression results for the difference-in-differences analysis of

I(Restatement discovery), I(Restatement announcement), and I(Misstatement). For each of these

dependent variables, we use a traditional logit specification and a conditional logit specification

that conditions on each matched pair of a partner rotation observation and its corresponding

matched non-rotation observation. Using Equation (1), we regress the indicator variable

I(Restatement discovery) on the indicators TREAT and POST, as well as TREAT*POST, which

is the difference-in-differences coefficient of interest, a set of control variables, and fixed

effects for each SEC office that issues comment letters. Following Equation (2) we perform a

26
similar regression for I(Restatement announcement), and following Equation (3), for

I(Misstatement).

For I(Restatement discovery), the coefficient on TREAT*POST is positive and

significant in the logit specification (coeff. = 0.985; p < 0.05) and slightly weaker in the

conditional logit specification (coeff. 0.862; p < 0.10). The conditional logit result corresponds

to a relative increase in I(Restatement discovery) of 4.6 percentage points. 10 For I(Restatement

announcement), the coefficient on TREAT*POST is positive and significant in the logit

specification (coeff. = 0.879; p < 0.05) and again slightly weaker in the conditional logit

specification (coeff. 0.741; p < 0.10). The conditional logit result corresponds to a relative

increase in I(Restatement announcement) of 3.8 percentage points. For I(Misstatement), the

coefficient on TREAT*POST is positive but not significant in the logit or conditional logit

specifications. The control variables Return on assets and Market value are the most significant

for the restatement discovery and announcement dependent variables. For restatement

discovery and announcement, the coefficient on Total accruals is inconsistent with the

prediction of Dechow et al. (2011). It is important to note, however, that our primary outcome

variables are the discovery and announcement of a restatement, and hence, our explanatory

control variables are lagged by one year to reflect the likelihood that the period being restated is

the prior year. Where misstatement is the dependent variable, the coefficient on Total accurals

is significant and in the predicted direction (coeff. = 1.394; p < 0.01). Overall, Table 4 provides

support for H1 that partner rotations are associated with increases in restatement

announcements and discoveries.

We examine the differences in the types of restatements made by partner rotation and

non-rotation firms. In untabulated analysis we find that the restatement discoveries and

10
The relative increase is computed as the change in the expected value of the I(Restatement discovery) log odds
ratio, setting POST = 1 and varying TREAT between 0 and 1, then converting the change in odds to a change in
probability that I(Restatement discovery) = 1.

27
announcements for partner change firms are generally similar to those of non-rotation firms,

and primarily relate to related party or subsidiary issues, accounting for income taxes, cash

flow statement classification errors, and fixed asset impairment issues.

Write-Downs and Special Items Analysis

Figure 2, Panels D, E, and F illustrate the effects of partner rotation on I(Write-down),

I(Negative special item), and I(Positive special item), respectively. Results are consistent with

the inferences in Table 3. The effects of new partner rotation on I(Write-down) appear

insignificant. The difference in I(Negative special item) between partner rotation and non-

rotation firms increases from Year -1 to Year 0, with marginal significance. Specifically,

I(Negative special item) for partner rotation firms increases from 52.0 percent and 54.6 percent

in Years -2 and -1 to 55.1 percent and 58.8 percent in Years 0 and 1, respectively. However,

I(Negative special item) for non-rotation firms actually decreases from the pre- to the post-

rotation period, declining from 55.5 percent and 61.0 percent in Years -2 and -1, respectively,

to 52.7 percent and 57.1 percent in Years 0 and 1, respectively. The difference in I(Positive

special item) between partner rotation and non-rotation firms clearly decreases in Year -1 to

Year 0. While I(Positive special item) for partner rotation firms is fairly flat in the pre- and

post-rotation periods averaging out at 17.3 percent in both periods, I(Positive special item) for

non-rotation firms substantially increases from 14.5 percent and 12.7 percent in Years -2 and -1

to 23.4 percent and 23.2 percent in Years 0 and 1, respectively. Therefore, the foregoing plots

suggest that, relative to non-rotation firms, I(Negative special item) increases and I(Postive

special item) decreases for rotation firms following partner rotation.

Table 5 presents regression results for the difference-in-differences analysis of write-

downs and special items using Equations (4), (5), and (6), where the indicators I(Write-down),

I(Negative special item), and I(Positive special item), are regressed on TREAT, POST,

TREAT*POST. For each equation, the first column presents the traditional logit specification

28
and the second column presents the conditional logit specification. For the dependent variable

I(Write-down), the coefficient on TREAT*POST is insignificantly different from zero in both

logit and conditional logit specifications, indicating that in our sample partner rotation does not

have a statistically significant effect on the incidence of write-downs. For the dependent

variable I(Negative special item), the coefficient on TREAT*POST is positive, but not

significant at conventional levels in both logit and conditional logit specifications. For the

dependent variable I(Positive special item), the coefficient on TREAT*POST is negative and

significant in the logit specification (coeff. = -0.672; p < 0.05) and in the conditional logit

specification (coeff. = -0.692; p < 0.05), which suggests a relative decrease in positive special

items for rotation firms following partner rotation of 8.6 percentage points. The control

variables, Intangibles, I(Book to market > 1), Operating income, and log (Market value), are all

significant for explaining I(Write-down) and their signs are consistent with the prior literature;

however, they are less consistent in explaining I(Negative special item) and I(Positive special

item). In an additional analysis discussed at the end of the paper, we run the same tests in a

clean subsample in which the identification non-rotation control firms are unambiguous. Within

this subsample, the positive special item results are no longer significant. Consequently, we put

less of an emphasis on these findings.

Allowances Analysis

In Figure 2, Panels G through M illustrate the levels of allowances surrounding partner

rotations. Panel G shows a clear increase in the Total allowance, the sum of all allowance

accounts, from the pre-rotation to the post-rotation period. Specifically, the Total allowance for

partner rotation firms increases from 1.93 percent and 2.35 percent of total assets in Years -2

and -1, respectively, to 2.54 percent and 3.00 percent of total assets in Years 0 and 1, while the

Total allowance for non-rotation firms generally decreases from 4.02 percent and 3.68 percent

of total assets in Years -2 and -1, respectively, to 3.48 percent and 3.81 percent of total assets in

29
Years 0 and 1, respectively. Because the Deferred tax asset allowance is significantly larger

than the other allowances, it is the primary driver of the changes in Total allowance. A quick

examination of all allowances in Figure 2 shows that that Deferred tax asset allowance panel

and the Total allowance panel are the most similar.

Table 6, Panel A presents the OLS regression results for the difference-in-differences

analysis of allowances using Equation (7), where the allowances (as a percentage of adjusted

total assets) are regressed on TREAT, POST, and TREAT*POST. We include controls for

financial statement variables likely to influence the allowance and reserve balances as well as

fixed effects for each matched pair. In the first results column, the dependent variable is Total

allowance and the coefficient on TREAT*POST is positive and significant (coeff. = 0.809; p <

0.10), indicating that partner rotations are associated with an increase in Total allowance of 0.8

percent of assets following partner rotations. The remaining columns provide similar analyses

for the individual allowances; and consistent with Figure 2, we observe that the largest

contribution (86 percent) to the increase in allowances is from Deferred tax asset allowance

(TREAT*POST coeff. = 0.769; p < 0.10). 11 The Other allowance column shows a positive

coefficient (TREAT*POST coeff. = 0.092; p > 0.10), but is statistically insignificant, and the

TREAT*POST coefficients for the remaining allowances are also are insignificant (e.g.,

Allowance for doubtful accounts, Sales returns allowance, Inventory allowance, and Loan loss

allowance). Several of the control variables are significant and appear to consistently explain

the allowance and reserve balances in the predicted manner. 12

11
The percentage is calculated by comparing the coefficient on Deferred tax asset allowance to all the positive
allowance coefficients: 0.769 / (0.018 + 0.769 + 0.019 + 0.092).
12
In a untabulated analyses, we include a control variable for expected future profitability using next years
forecasted ROA (Consensus Year Ahead EPS * Shares Outstanding / Total Assets, from FactSet) or ROAt+1 for
those firms without analyst coverage, as the deferred tax asset valuation allowance is related to expected future
earnings. We find that our inferences are unchanged.

30
 In Panels B and C, we provide some additional analyses regarding the Deferred tax

asset allowance, to confirm that the result is not due to a small number of outliers. Panel B

provides statistics on the percentage of firms with deferred tax assets that experience increases

and decreases in the Deferred tax asset allowance from the pre-rotation period to the post-

rotation period and Panel C provides a regression analysis predicting whether a firm increases

its Deferred tax asset allowance as a function of TREAT plus the control variables used in

Panel A but measured in Year 0 (i.e., the partner rotation year). Panel B indicates partner

rotation firms are more likely to record increases in the Deferred tax asset allowance account,

post-rotation, at 60.9 percent, compared to non-rotation firms at 46.7 percent (p < 0.05). The

regression analysis in Panel C confirms this inference as the coefficient on TREAT is positive

and significant (TREAT coeff. = 0.721; p < 0.05). Taken together, these findings provide some

support for H3, that new audit partners have influence on the clients total allowances, and in

particular the deferred tax valuation allowance. 13

Additional Analyses

We perform additional analyses to corroborate our findings. First, in the main analyses,

we define a non-rotation as consecutive comment letters that have at least one copied audit

partner name in common. However, in 30 percent of these cases there is another name copied

which changes from the pre-period to the post-period, a potential source of measurement error

because the name that changed could, in fact, reflect a partner rotation. Hence, we repeat our

main analyses using a clean subsample, in which all names are the same in the pre-period and

the post-period for the non-rotation firms. The incidence of partner rotation in this subsample is

19.9 percent, nearly equal to the 20 percent expected if partner rotations occur every five years

and consecutive comment letters are evenly distributed across partners tenures.

13
Similar to the Allowance for doubtful accounts results, in unreported analysis, we find insignificant changes in
the bad debt expense following rotation.

31
 Table 7 presents all main results for this subsample, and consistent with measurement

error, we find that our results are generally stronger. Panels A, B, and C report the key

difference-in-differences coefficients on TREAT*POST, which can be compared to the results

in Tables 4, 5 and 6, respectively. Panel A shows that the relative increase in restatement

discoveries have larger coefficients and greater statistical significance compared to the full

sample (e.g., coeff. = 1.376, p < 0.01 compared to coeff. = 0.985, p < 0.05 for the main analysis

in Table 4). Panel B shows that the significant decrease in positive special items is still

negative, but insignificant in the clean subsample (e.g., coeff. = -0.400, p > 0.10 compared to

coeff. = -0.672, p < 0.05 for the main analysis in Table 5). Panel C shows that the increase in

total allowances (coeff. = 1.142, p < 0.05 compared to coeff. = 0.809, p < 0.10 for the main

analysis in Table 6 Panel A) and the deferred tax asset allowance (coeff. = 1.233, p < 0.05

compared to coeff. = 0.769, p < 0.10 for the main analysis in Table 6 Panel A) also have larger

coefficients and greater statistical significance in the clean subsample. Panels D and E illustrate

that the higher likelihood of increasing the deferred tax asset allowance in the clean subsample

is similar to that of Table 6 Panels B and C, respectively.

Second, in our main analyses we rely on Audit Analytics database of restatements to

identify material restatements. To ensure our findings do indeed only include material

restatements, we repeat our restatement announcement analyses using only 8-K non-reliance

restatement announcements. Specifically, filing 8-K item 4.02 is required if, previously issued

financial statements should not be relied upon because of an error in the statements, or if, the

auditor believes that previously issued audit reports or interim reviews on financial statements

should not be relied upon (SEC 2012). These restatements only include those that are material

enough to warrant a warning to investors. We identified 8-K 4.02 restatement announcements

using EDGAR filings data by extracting item numbers from all 8-Ks filed during our sample

32
period, and all restatement announcement results are robust although slightly weaker (p < 0.10)

using this subset of restatements.

Third, to further rule out concerns that our findings reflect a damage control measure in

response to the issues raised in the comment letter, or to an anticipated restatement, we

investigate the comment letter subject categories and the 3-day cumulative abnormal returns

(CARs) surrounding the comment letter disclosure for both the partner rotation firms and the

non-rotation control firms. The frequency of receiving comment letters for the following topics,

as coded by Audit Analytics, is not statistically different for partner rotation and non-rotation

firms: Accounting Standards; Operational, Controls, and Risk Assessments; Non-Standard and

Other Disclosures; Securities Regulations; New and Secondary Registrations; Mergers and

Acquisitions. Furthermore, if the comment letters for rotation firms address more serious issues

or reflect a greater propensity for an anticipated restatement that resulted in a voluntary

removal of an audit partner, then the market response to rotation firm comment letters should

be more severe than those for non-rotation control firms (Ryans 2015). We find no differences

in the 3-day CARs surrounding the comment letter disclosures between rotation firms and non-

rotation firms, further supporting the notion that our findings reflect the effects of partner

rotations rather than the effects of damage control measures.

Fourth, we scale each valuation allowance and reserve by the related balance sheet

account instead of total assets. For example, scaling Allowance for doubtful accounts by the

total receivables balance, rather than total assets. All main inferences are similar except that the

Deferred tax asset allowance inference is slightly weaker. Fourth, we find that all our main

inferences hold when we exclude partner rotations involving office changes, ruling out

concerns that our findings reflect the effect of moving to a specialist office.

33
 5. CONCLUSION

Audit partner rotation has been a key component of U.S. audit practice for over three

decades and is often regarded as a compromise to implementation of the complete fresh look

that would be obtained through audit firm rotation. Despite the fact that partner rotation is the

main requirement in the U.S. for the provision of fresh looks at audit engagements, limited U.S.

evidence exists on the benefits of partner rotation, because audit partner names are not

disclosed in U.S audit reports. Such evidence is especially important as the requirement for full

U.S. audit firm rotation is periodically proposed by regulators, and it is necessary to understand

the effectiveness of current methods before considering costlier regulation.

Contrary to the findings of prior research, this study provides some initial U.S. public-

company evidence suggesting that auditor partner rotation provides a fresh look at the audit

engagement. Specifically, using SEC comment letter correspondences to identify U.S. audit

partner rotations between 2006 and 2014, relative to non-rotation firms, we find increases in

restatement discoveries and announcements, and deferred tax valuation allowances following

partner rotations. While these findings suggest the fresh look effects are fairly modest, they still

provide some support for the notion that incoming audit partners in the U.S. often require

changes to the financial statements that were not required by the previous engagement partners.

Our studys evidence is also relevant to PCAOBs recent rule requiring the disclosure of

partner names starting in 2017. Opponents of the proposal (e.g., CAQ 2014) suggest that the

disclosure of audit partner names would not provide meaningful or relevant information to

investors. However, as the disclosure of audit partner names would reveal the partner rotation

schedules, our findings indicate that the disclosure of partner names should provide some

useful and relevant information. In particular, such disclosure will enable financial statement

users to anticipate and appreciate potential financial reporting effects of the partner rotations.

34
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37

Adjusted assetsi,t
Agei,t
Allowance for doubtful
accountsi,t
Book to marketi,t-1
Cost of goods soldi,t
Deferred tax asset
allowancei,t
I(Big 4 auditori,t-1)
I(Book to marketi,t-1 > 1)
I(Increase DTAi)
I(Issuancei,t-1)
I(Lossi,t)
I(Misstatementi,t)
I(Negative special itemi,t)
I(Positive special itemi,t)
I(Restatement
announcementi,t)
I(Restatement discoveryi,t)
I(Write-downi,t)
Intangiblesi,t-1
Inventoryi,t-1 Firm i's change in scaled inventory from year t-2 to year t-1 (INVTi,t-1/ATi,t-1
Inventory allowancei,t
Leveragei,t-1
Loan loss allowancei,t
Market valuei,t
Non-cash net assetsi,t
APPENDIX A
Variable Definitions
Sum of all hand-collected ending allowance account balances for firm i in year t
plus ATi,t;
Number of years since the first year of Compustat coverage for firm i as of year
t;
Hand-collected ending allowance for doubtful accounts for firm i in year t,
multiplied by 100, scaled by Adjusted assetsi,t
Firm i's total assets at the end of year t-1 scaled by the sum of market
capitalization plus total assets minus the book value of total common equity as of
year-end t-1 (ATi,t-1 / (CSHOi,t-1*PRCC_Fi,t-1 + ATi,t-1 - CEQi,t-1));
Firm is unscaled cost of goods sold in year t (COGSi,t);
Hand-collected ending deferred tax asset valuation allowance for firm i in year t,
multiplied by 100, scaled by Adjusted assetsi,t;
1 if firm i is audited by Deloitte & Touche, Ernst & Young, KPMG, or
PricewaterhouseCoopers in year t-1, 0 otherwise;
1 if Book to marketi,t-1 > 1, 0 otherwise;
1 when the mean Deferred tax asset allowance increases from the pre-period
(POST = 0) to the post-period (POST = 1), and 0 otherwise, such that there is
one observation per four-year period;
1 if either DLTISi,t-1 > 0 or SSTKi,t-1 > 0, 0 otherwise;
1 if IBi,t < 0, 0 otherwise;
1 if firm i restates any portion of fiscal year t, 0 otherwise;
1 if SPIi,t < 0, 0 otherwise;
1 if SPIi,t > 0, 0 otherwise;
1 if firm i announced a restatement during the period starting one day after the
annual report covering year t-1 is filed and ending on the day that the annual
report covering year t is filed, and did not disclose that the restatement was
prompted by the SEC, and if it was announced by a partner rotation firm in the
post period, the restatement was manually researched to ensure that it does not
relate to the previous years' comment letter conversations, 0 otherwise;
1 if firm i discovered a restatement during the period starting one day after the
annual report covering year t-1 is filed and ending on the day that the annual
report covering year t is filed, and did not disclose that the restatement was
prompted by the SEC, and if it was announced by a partner rotation firm in the
post period, the restatement was manually researched to ensure that it does not
relate to the previous years' comment letter conversations, 0 otherwise;
1 if either WDPi,t < 0 or GDWLIPi,t < 0, 0 otherwise;
Firm i's intangible assets for year t-1 scaled by total assets as of the end of year t-
1 (INTANi,t-1 / ATi,t-1);
INVTi,t-2/ATi,t-2);
Hand-collected ending allowance for inventory obsolescence for firm i in year t,
multiplied by 100, scaled by Adjusted assetsi,t;
Firm is debt-to-equity ratio at the end of year t-1 ((DD1i,t-1 + DLTTi,t-1)/SEQi,t-1),
winsorized at the 99% quantile and negative values are set to zero;
Hand-collected ending allowance for loan losses for firm i in year t, multiplied
by 100, scaled by Adjusted assetsi,t;
Market value of equity for firm i at the end of year t (CSHOi,t*PRCC_Fi,t);
Non-cash net assets for firm i at the end of year t (ATi,t CHEi,t LTi,t PSTKi,t);
(Continued)
38
 Other allowancei,t
Operating incomei,t
POSTi,t
Receivablesi,t-1
Return on assetsi,t
Return on assetsi,t
Sales returns allowancei,t
Salesi,t
Soft assetsi,t-1
Time in inventoryi,t
Time in receivablesi,t
Total accrualsi,t-1
Total allowancei,t
TREATi,t
This appendix presents variable definitions for all variables in our main analyses. Data notated in all upper-cases are from the
Compustat annual file.
Hand-collected ending other allowance accounts for firm i in year t, multiplied
by 100, scaled by Adjusted assetsi,t;
Firm i's operating income after depreciation in year t divided by its total assets at
year t-1 (OIADPi,t / ATi,t-1), winsorized at 1.0 and -1.0;
1 in Year 0 and Year 1, 0 in Year -2 and Year -1;
Firm is change in scaled receivables from year t-2 to year t-1 (RECTi,t-1/ATi,t-1
RECTi,t-2/ATi,t-2);
Firm i's net income in year t divided by its total assets at year t-1 (NIi,t / ATi,t-1),
winsorized at 1.0 and -1.0;
Change in Return on assets for firm i from year t-1 to year t (Return on assetsi,t -
Return on assetsi,t-1);
Ending sales returns allowance for firm i in year t, multiplied by 100, scaled by
Adjusted assetsi,t;
Firm is unscaled sales in year t (SALEi,t);
Firm is soft assets at the end of year t-1 ((ATi,t-1 PPENTi,t-1 CHEi,t-1)/ATi,t-1);
INVTi,t plus hand-collected ending allowance for inventory obsolescence for firm
i in year t, all scaled by COGSi,t;
Gross accounts receivable scaled by sales for firm i in year t ((RECTi,t + RECDi,,t)
/ SALEi,t);
Change in firm is Non-cash net assets from year t-1 to year t, scaled by average
total assets ((Non-cash net assetsi,t - Non-cash net assetsi,t-1)/(ATi,t + ATi,t-1)/2);
Sum of all ending allowance account balances for firm i in year t, multiplied by
100, scaled by Adjusted assetsi,t; and,
1 if firm i is a partner rotation firm in time t, 0 otherwise.
39
 APPENDIX B
Panel 1: Example of Comment Letter Response with the Previous Audit Partner

Engagement partner for fiscal year 2009

40
Panel 2: Example of Comment Letter Response with the New Audit Partner

Engagement partner for fiscal year 2010

41
 FIGURE 1
Timeline

This figure presents a timeline to illustrate the process by which partner rotations are identified, and restatement discoveries and announcements and misstatement are assigned to the pre- and
post-rotation periods. The first year in which the new partner is named is Year 0 for our analysis.

42
 FIGURE 2
Plots of Financial Reporting Measures by Year Relative to Partner Rotation

Panel A: I(Restatement discovery) Panel B: I(Restatement announcement)

0.15 0.12
Control
0.12 0.09

0.09
0.06
0.06
Treatment
0.03
0.03
Partner Partner
Rotation Rotation
0.00 0.00
-2 -1 0 1 -2 -1 0 1

Panel C: I(Misstatement) Panel D: I(Write-down)

0.20 0.30

0.15 0.25

0.10 0.20

Partner Partner
Rotation Rotation
0.05 0.15
-2 -1 0 1 -2 -1 0 1

Panel E: I(Negative special item) Panel F: I(Positive special item)

0.65 0.25

0.60 0.20

0.55 0.15

Partner Partner
Rotation Rotation
0.50 0.10
-2 -1 0 1 -2 -1 0 1

43
Panel G: Total allowance Panel H: Allowance for doubtful accounts
4.50 0.60

3.50 Control
0.40

2.50 Treatment

Partner Partner
Rotation Rotation
1.50 0.20
-2 -1 0 1 -2 -1 0 1

Panel I: Sales returns allowance Panel J: Inventory allowance

0.12 0.20

0.10 0.10

Partner Partner
Rotation Rotation
0.08 0.00
-2 -1 0 1 -2 -1 0 1

Panel K: Deferred tax asset allowance Panel L: Loan loss allowance

3.50 0.20

2.50
0.15

1.50

Partner Partner
Rotation Rotation
0.50 0.10
-2 -1 0 1 -2 -1 0 1

Panel M: Other allowance

0.30

0.15

Partner
Rotation
0.00
-2 -1 0 1
This figure presents plots of the levels of the financial reporting measures used in our partner rotation analysis. The solid line
presents the level of each measure for partner rotation firms (treatment), and the dotted line presents the level of each measure for

44
matched non-rotation firms (control). For partner rotation firms, Year 0 is the first year the new partner is responsible for auditing
the financial statements, and Year -1 is the last year under the outgoing audit partner.

45
 TABLE 1
Sample

Panel A: Sample attrition

Percent of
Firm-years Firms Compustat firms
Detecting partner rotations:
Compustat variables available (2004 2014) 75,505 11,710 100.00%
Receive an SEC comment letter 30,265 8,940 76.35%
Receive an SEC comment letter in two of three years 19,761 6,626 56.58%
Copy an audit partner by name in two of three years 1,240 568 4.85%
Partner rotations identified 278 241 2.06%
Partner non-rotations identified 962 507 4.33%

Availability of suitable matches and control variables: Firm-years

Restatement tests (198 rotations): POST = 0 POST = 1
Rotation firms (183 unique firms) 384 367
Non-rotation firms (116 unique firms) 384 367

Write-down and special item tests (205 rotations):

Rotation firms (189 unique firms) 405 382
Non-rotation firms (121 unique firms) 405 382

Allowance and reserve account tests (192 rotations):

Rotation firms (179 unique firms) 383 354
Non-rotation firms (114 unique firms) 383 354

46
Panel B: Industry Composition

Industry Partner Rotation Sample Compustat

Trading 13.17% 14.71%
Banking 10.73% 10.04%
Computer Software 10.73% 7.38%
Pharmaceutical Products 5.37% 6.85%
Petroleum and Natural Gas 4.88% 5.12%
Electronic Equipment 7.80% 4.97%
Business Services 4.88% 3.79%
Retail 4.88% 3.26%
Communication 3.90% 2.96%
Medical Equipment 2.93% 2.71%
Insurance 6.34% 2.48%
Transportation 5.85% 2.44%
Wholesale 0.98% 2.43%
Precious Metals 0.98% 2.35%
Machinery 0.49% 2.32%
Utilities 2.93% 2.09%
Chemicals 1.46% 1.64%
Measuring and Control Equipment 1.46% 1.52%
Electrical Equipment 0.49% 1.40%
Computer Hardware 2.44% 1.38%
Healthcare 1.46% 1.27%
Construction Materials 0.49% 1.23%
Food Products 0.98% 1.23%
Automobiles and Trucks 1.46% 1.22%
Restaurants, Hotels, Motels 0.00% 1.17%
Real Estate 0.00% 1.11%
Entertainment 0.00% 1.11%
Consumer Goods 0.49% 1.04%
Steel Works Etc. 0.00% 0.96%
Apparel 0.49% 0.86%
Personal Services 0.49% 0.84%
Construction 0.98% 0.80%
Business Supplies 0.00% 0.79%
Almost Nothing 0.00% 0.69%
Recreation 0.00% 0.52%
Rubber and Plastic Products 0.00% 0.46%
Printing and Publishing 0.00% 0.45%
Aircraft 0.49% 0.37%
Agriculture 0.00% 0.32%
Candy & Soda 0.00% 0.30%
Beer & Liquor 0.00% 0.29%
Coal 0.00% 0.28%
Textiles 0.00% 0.18%
Shipping Containers 0.00% 0.17%
Defense 0.00% 0.15%
Shipbuilding, Railroad Equipment 0.00% 0.14%
Fabricated Products 0.00% 0.13%
Tobacco Products 0.00% 0.10%

47
This table presents details of our sample. Panel A illustrates the sample attrition, which primarily occurs because only 4.85
percent of firms have comment letters and copy audit partners by name twice during a three-year window. Panel B presents the
industry composition of our partner rotation sample and the overall Compustat population. Overall, our samples industry
composition is similar to that of Compustat. Our sample lacks representation from some of the smaller industries.

48
 TABLE 2
Descriptive Statistics

Partner Rotation Firms Non-Rotation Firms Compustat Firms

Mean Median Mean Median Mean Median
Panel A: Restatements variables
N = 751 N = 751 N = 58,475
I(Restatement discoveryi,t) 0.068 0.000 0.080 0.000
I(Restatement announcementi,t) 0.068 0.000 0.083 0.000 0.066 0.000
I(Misstatementi,t) 0.148 0.000 0.128 0.000 0.138 0.000
Total accrualsi,t-1 0.019 0.012 0.015 0.014 -0.012 0.016
Receivablesi,t-1 -0.004 -0.001 0.005 0.001 -0.002 0.000
Inventoryi,t-1 0.001 0.000 0.001 0.000 0.000 0.000
Soft assetsi,t-1 0.625 0.657 0.635 0.661 0.583 0.616
Leveragei,t-1 0.928 0.405 1.338 0.476 0.797 0.237
I(Issuancei,t-1) 0.939 1.000 0.964 1.000 0.879 1.000
Return on assetsi,t-1 -0.004 -0.001 -0.004 0.000 0.003 0.000
Return on assetsi,t-1 0.035 0.038 0.004 0.024 -0.056 0.017
I(Big 4 auditori,t-1) 0.912 1.000 0.876 1.000 0.643 1.000
Agei,t 22.322 18.000 21.551 18.000 18.736 14.000
Book to marketi,t-1 0.737 0.780 0.779 0.823 0.693 0.700
Market valuei,t 12,733 2,752 6,380 1,872 4,379 329
Panel B: Write-downs and special items variables
N = 787 N = 787 N = 69,099
I(Write-downi,t) 0.260 0.000 0.231 0.000 0.191 0.000
I(Negative special itemi,t) 0.550 1.000 0.565 1.000 0.441 0.000
I(Positive special itemi,t) 0.173 0.000 0.183 0.000 0.148 0.000
I(Book to marketi,t-1>1) 0.161 0.000 0.179 0.000 0.169 0.000
Intangiblesi,t-1 0.159 0.067 0.183 0.051 0.128 0.030
Operating incomei,t 0.064 0.062 0.054 0.053 0.072 0.051
Market valuei,t 12,466 2,752 6,454 1,903 4,305 282
Panel C: Allowances variables
N = 737 N = 737 N = 67,422
Total allowancei,t 2.434 0.702 3.748 1.165
Allowance for doubtful accountsi,t 0.468 0.117 0.350 0.100
Inventory allowancei,t 0.059 0.000 0.161 0.000
Deferred tax asset allowancei,t 1.470 0.000 2.842 0.006
Sales returns allowancei,t 0.109 0.000 0.096 0.000
Loan loss allowancei,t 0.157 0.000 0.148 0.000
Other allowancei,t 0.173 0.000 0.151 0.000
Time in receivablesi,t 1.272 0.183 1.266 0.182 1.736 0.169
Time in inventoryi,t 0.513 0.075 1.304 0.082 0.404 0.088
Return on assetsi,t 0.036 0.035 0.014 0.025 -0.050 0.016
I(Lossi,t) 0.217 0.000 0.309 0.000 0.349 0.000
Book to marketi,t 0.750 0.788 0.786 0.821 0.717 0.720
Salesi,t 9,715 1,765 7,826 1,098 3,729 228
Cost of goods soldi,t 5,682 940 3,957 615 2,487 116
Market valuei,t 13,078 3,168 6,794 2,030 4,426 329

This table presents the mean and median of all variables in our main tests separately for the partner rotation sample, the matched
non-rotation sample, and the full Compustat sample. Refer to Appendix A for variable definitions.

49
 TABLE 3
Conditional Means of Financial Reporting Measures

I(Restatement discovery) I(Restatement announcement)

TREAT = 1 TREAT = 0 TREAT = 1 TREAT = 0
POST = 0 6.77 11.20 POST = 0 6.25 10.68
POST = 1 6.81 4.63 POST = 1 7.36 5.72
Differences 0.04 -6.57 Differences 1.11 -4.96

I(Misstatement) I(Write-down)
TREAT = 1 TREAT = 0 TREAT = 1 TREAT = 0
POST = 0 15.89 15.89 POST = 0 27.65 24.44
POST = 1 13.62 9.54 POST = 1 24.35 21.73
Differences -3.27 -6.35 Differences -3.30 -2.71

I(Negative special item) I(Positive special item)

TREAT = 1 TREAT = 0 TREAT = 1 TREAT = 0
POST = 0 53.33 58.27 POST = 0 17.28 13.58
POST = 1 56.81 54.71 POST = 1 17.28 23.3
Differences 3.48 -3.56 Differences 0.00 9.72

Total allowance Allowance for doubtful accounts

TREAT = 1 TREAT = 0 TREAT = 1 TREAT = 0
POST = 0 2.14 3.85 POST = 0 0.48 0.33
POST = 1 2.75 3.64 POST = 1 0.46 0.37
Differences 0.61 -0.21 Differences -0.02 0.04

Sales returns allowance Inventory allowance

TREAT = 1 TREAT = 0 TREAT = 1 TREAT = 0
POST = 0 0.11 0.10 POST = 0 0.05 0.13
POST = 1 0.11 0.09 POST = 1 0.07 0.19
Differences 0.00 -0.01 Differences 0.02 0.06

50
 Deferred tax asset allowance Loan loss allowance
TREAT = 1 TREAT = 0 TREAT = 1 TREAT = 0
POST = 0 1.22 2.98 POST = 0 0.17 0.17
POST = 1 1.74 2.69 POST = 1 0.15 0.13
Differences 0.52 -0.29 Differences -0.02 -0.04

Other allowance

TREAT = 1 TREAT = 0

POST = 0 0.12 0.14

POST = 1 0.23 0.16
Differences 0.11 0.02

This table presents the mean of our financial reporting measures for partner rotation firms (TREAT = 1) and non-rotation control
firms (TREAT = 0), in pre-rotation period (POST = 0) and the post-rotation period (POST = 1). Values for I(Restatement
discovery), I(Restatement announcement), I(Misstatement), I(Write-down), I(Negative special item), and I(Positive special item)
are multiplied by 100 so that all variables represent percentages. See Table 1, Panel A for detailed sample sizes and Appendix A
for variable definitions.

51
 TABLE 4
Restatements Analysis

Exp. Logit Conditional Logit Exp. Logit Conditional Logit Exp. Logit Conditional Logit
Sign I(Restatement discoveryi,t) Sign I(Restatement announcementi,t) Sign I(Misstatement,t)
TREATi,t * POSTi,t + 0.985** 0.862* + 0.879** 0.741* - 0.367 0.429
(2.31) (1.93) (2.13) (1.72) (1.17) (1.23)
TREATi,t -0.355 -0.248 -0.372 -0.243 0.209 0.369
(-1.30) (-0.78) (-1.33) (-0.76) (1.00) (1.46)
POSTi,t -1.016*** -1.010*** -0.709** -0.698*** -0.537** -0.608**
(-3.32) (-3.11) (-2.46) (-2.30) (-2.30) (-2.36)
Total accrualsi,t-1 -1.114 -2.200 -0.739 -1.680 1.394*** 1.540***
(-1.57) (-2.64) (-1.08) (-2.19) (2.79) (2.61)
Receivablesi,t-1 0.847 1.040 0.322 0.063 -1.738 -2.670
(0.53) (0.50) (0.20) (0.03) (-1.36) (-1.39)
Inventoryi,t-1 -0.334 -0.240 -3.282 -2.770 -2.80 -2.750
(-0.10) (-0.06) (-0.95) (-0.72) (-0.95) (-0.86)
Soft assetsi,t-1 0.089 1.170 0.011 0.857 0.517 0.376
(0.20) (1.45) (0.02) (1.08) (1.39) (0.59)
Leveragei,t-1 0.020 0.027 0.020 0.024 -0.02 0.035
(0.37) (0.33) (0.37) (0.30) (-0.48) (0.66)
I(Issuancei,t-1) 0.687 0.274 0.552 0.263 0.741* -0.126
(1.29) (0.42) (1.05) (0.41) (1.65) (-0.24)
Return on assetsi,t-1 1.080 1.170 0.957 0.900 0.661 0.787
(1.64) (1.38) (1.49) (1.09) (1.23) (1.16)
Return on assetsi,t-1 -1.124* -1.420 -1.363** -1.520 -1.733*** -1.880**
(-1.68) (-1.40) (-2.05) (-1.58) (-3.05) (-2.23)
I(Big 4 auditori,t-1) -0.395 -0.660 -0.487 -0.738 -0.469* -1.170***
(-1.14) (-1.06) (-1.44) (-1.20) (-1.82) (-2.59)
Agei,t 0.002 0.003 -0.001 -0.003 0.003 0.009
(0.21) (0.22) (-0.15) (-0.22) (0.48) (0.83)
Book to marketi,t-1 0.158 0.232 0.219 0.408 0.165 -0.171
(0.41) (0.39) (0.58) (0.69) (0.54) (-0.38)
log(Market valuei,t) -0.133** -0.308** -0.110* -0.304** -0.061 -0.071
(-2.05) (-2.09) (-1.71) (-2.10) (-1.24) (-0.70)

SEC office fixed effects Included Included Included Included Included Included
N 1,502 1,502 1,502 1,502 1,502 1,502
Psuedo R2 0.07 0.15 0.06 0.13 0.06 0.09

52
This table presents logit and conditional logit regression results examining the effect of partner rotation on restatements. Conditional logit regressions are estimated using matched
pairs as strata. The "Exp. Sign" column indicates "+" where we hypothesize the coefficient to be positive and "-" where we hypothesize the coefficient to be negative. N reports the
number of firm-year observations. *,**,*** indicate significance at the 0.10, 0.05, and 0.01 levels, respectively, using two-tailed p-values. Z-statistics are reported in parentheses
below the coefficients. Refer to Appendix A for variable definitions.

53
 TABLE 5
Write-downs and Special Items Analysis

Exp. Logit Conditional Logit Exp. Logit Conditional Logit Exp. Logit Conditional Logit
Sign I(Write-downi,t) Sign I(Negative special itemi,t) Sign I(Positive special itemi,t)
TREATi,t * POSTi,t + -0.019 -0.074 + 0.331 0.369 - -0.672** -0.692**
(-0.08) (-0.28) (1.58) (1.62) (-2.50) (-2.46)
TREATi,t 0.236 0.380** -0.199 -0.202 0.253 0.160
(1.42) (2.04) (-1.36) (-1.25) (1.28) (0.76)
POSTi,t -0.249 -0.299 -0.188 -0.192 0.645*** 0.677***
(-1.42) (-1.56) (-1.26) (-1.18) (3.39) (3.36)
Intangiblesi,t-1 2.072*** 1.967*** 2.372 1.736*** -0.597* -0.487
(7.48) (4.07) (8.60) (4.11) (-1.76) (-0.98)
I(Book-to-marketi,t-1 > 1) 0.722*** 0.924*** -0.125 0.016 0.209 0.139
(4.66) (4.33) (-0.87) (0.09) (1.20) (0.61)
Operating incomei,t -1.998*** -2.479*** -0.617 0.141 -1.009* -1.642*
(-3.35) (-2.72) (-1.37) (0.22) (-1.65) (-1.92)
log(Market valuei,t) 0.076** -0.139* 0.058** -0.052 0.081** 0.365***
(2.31) (-1.75) (2.09) (-0.82) (2.25) (4.05)

N 1,574 1,574 1,574 1,574 1,574 1,574

Pseudo R2 0.08 0.04 0.08 0.01 0.03 0.02

This table presents logit and conditional logit regression results examining the effect of partner rotation on write-downs and special items. The coefficients on TREATi,t*POSTi,t indicate that
partner rotation is associated with a marginal increase in I(Negative special item) and a significant decrease in I(Positive special item). Conditional logit regressions are estimated using matched
pairs as strata. The "Exp. Sign" column indicates "+" where we hypothesize the coefficient to be positive and "-" where we hypothesize the coefficient to be negative. N reports the number of
firm-year observations. *,**,*** indicate significance at the 0.10, 0.05, and 0.01 levels, respectively, using two-tailed p-values. Z-statistics are reported in parentheses below the coefficients.
Refer to Appendix A for variable definitions.

54
 TABLE 6
Allowances Analysis

Panel A: Regression Results

Allowance for Deferred tax
Total doubtful Sales returns Inventory asset Loan loss Other
Exp. Sign. allowancei,t accountsi,t allowancei,t allowancei,t allowancei,t allowancei,t allowancei,t
TREATi,t * POSTi,t + 0.809* -0.055 0.018 -0.034 0.769* 0.019 0.092
(1.83) (-0.52) (0.40) (-0.73) (1.86) (0.52) (0.86)
TREATi,t -0.869*** 0.168** 0.023 -0.071** -1.003*** 0.000 0.014
(-2.78) (2.24) (0.70) (-2.13) (-3.42) (-0.02) (0.19)
POSTi,t -0.231 0.025 -0.015 0.063* -0.234 -0.031 -0.039
(-0.73) (0.33) (-0.48) (1.90) (-0.79) (-1.16) (-0.51)
Time in receivablesi,t 0.007 0.006 -0.008 0.000 0.030 -0.014* -0.007
(0.09) (0.30) (-0.85) (0.01) (0.38) (-1.93) (-0.36)
Time in inventoryi,t -0.016 0.002 0.000 -0.001 -0.005 -0.013*** 0.001
(-0.77) (0.35) (0.17) (-0.27) (-0.27) (-7.31) (0.13)
Return on assetsi,t -5.878*** 0.013 -0.163 0.157 -6.316*** 0.317*** 0.115
(-4.53) (0.04) (-1.21) (1.14) (-5.20) (2.87) (0.37)
I(Lossi,t) 0.967** 0.153* -0.078** 0.021 0.644* 0.124*** 0.103
(2.56) (1.69) (-1.98) (0.52) (1.82) (3.87) (1.13)
Book to marketi,t -1.402* -0.422** -0.190** 0.007 -0.775 -0.090 0.069
(-1.94) (-2.43) (-2.54) (0.09) (-1.15) (-1.46) (0.39)
log(Salesi,t) -1.667*** -0.042 0.013 -0.039 -1.606*** -0.084*** 0.091
(-4.73) (-0.50) (0.37) (-1.05) (-4.87) (-2.80) (1.07)
log(Cost of goods soldi,t) 1.582*** 0.022 0.048 0.019 1.333*** 0.149*** 0.010
(5.55) (0.33) (1.63) (0.64) (5.00) (6.14) (0.15)
log(Market valuei,t) -1.100*** -0.032 -0.091*** -0.019 -0.803*** -0.038** -0.118**
(-5.41) (-0.65) (-4.31) (-0.87) (-4.22) (-2.17) (-2.42)
Intercept 11.185*** 0.653 0.489** 0.261 9.532*** 0.014 0.236
(5.82) (1.42) (2.46) (1.28) (5.30) (0.09) (0.51)
Matched pair fixed effects Included Included Included Included Included Included Included
N 1,474 1,474 1,474 1,474 1,474 1,474 1,474
Adj. R2 0.47 0.39 0.37 0.40 0.45 0.65 0.41
(Continued)

55
Panel B: Deferred tax asset allowance increase vs. decrease
Rotation Firms Non-Rotation Firms Difference
Percent Increase 60.92 46.79 14.13**
Percent Decrease 39.08 53.21 -14.13**

Panel C: Predicting an increase in the deferred tax asset allowance

Logit
Exp. I(Increase DTAi)
Sign Coeff. z-statistic
TREATi +_ _ 0.721** (2.19)
Time in receivablesi,0 0.035 (0.48)
Time in inventoryi,0 -0.044 (-0.72)
Return on assetsi,0 -12.324*** (-3.20)
I(Lossi,0) 0.031 (0.06)
Book to marketi,0 -0.647 (-0.74)
log(Salesi,0) -0.552 (-1.14)
log(Cost of goods soldi,0) 0.412 (1.15)
log(Market valuei,0) 0.338 (1.56)
Intercept -0.715 (-0.63)

N 196
Pseudo R2 0.16

Panel A presents OLS regression results examining the effect of audit partner rotation on valuation allowance and reserve accounts. The positive and significant coefficients on TREATi,t*POSTi,t
for Total allowance and Deferred tax asset allowance indicate that partner rotation has influence on the clients total allowances, and in particular the deferred tax valuation allowance. Fixed
effects are included for each matched pair. The "Exp. Sign" column indicates "+" where we hypothesize the coefficient to be positive. N reports the number of firm-year observations. *,**,***
indicate significance at the 0.10, 0.05, and 0.01 levels, respectively, using two-tailed p-values. T-statistics are reported in parentheses below the coefficients. The sample size in this analysis is
smaller than those used in Tables 4 and 5 because not all firms provide the necessary allowance disclosures. Panel B presents the percent of firms whose deferred tax asset allowance balances
increase or decrease from the pre-period (POST = 0) to the post-period (POST = 1), such that there is one observation per four-year period; observations without deferred tax assets are excluded.
T-tests for difference in means are presented in the Difference column. ** indicates statistical significance at the 0.05 level using two-tailed p-values. Panel C presents logit regression results
predicting an indicator variable which is equal to 1 when the mean Deferred tax asset allowance increases from the pre-period (POST = 0) to the post-period (POST = 1), and 0 otherwise,
such that there is one observation per four-year period; observations without deferred tax assets are excluded. **, *** indicate significance at the 0.05, and 0.01 levels, respectively, using two-
tailed p-values where there is no prediction. Z-statistics are reported in parentheses to the right of the coefficients. Refer to Appendix A for variable definitions.

56
 TABLE 7
Additional Analyses - Unambiguous Non-Rotation Sample

Panel A: Restatements Analysis (n = 1,046, 139 Rotations)

Exp. Logit Conditional Logit Exp. Logit Conditional Logit Exp. Logit Conditional Logit
Sign I(Restatement discoveryi,t) Sign I(Restatement announcementi,t) Sign I(Misstatementi,t)
TREATi,t * POSTi,t + 1.376*** 1.380** + 0.946* 0.972* - 0.440 0.600
(2.62) (2.48) (1.89) (1.85) (1.16) (1.36)

Psuedo R2 0.07 0.16 0.05 0.13 0.09 0.19

Panel B: Write-downs and Special Items Analysis (n = 1,092, 143 Rotations)

Exp. Logit Conditional Logit Exp. Logit Conditional Logit Exp. Logit Conditional Logit
Sign I(Write-downi,t) Sign I(Negative special itemi,t) Sign I(Positive special itemi,t)
TREATi,t * POSTi,t + 0.062 0.036 + 0.221 0.257 - -0.400 -0.422
(0.22) (0.12) (0.87) (0.93) (-1.20) (-1.19)

Pseudo R2 0.06 0.08 0.06 0.02 0.02 0.04

Panel C: Allowances Analysis Regression (n = 1,020, 133 Rotations)

Allowance for Deferred tax

Exp. Total doubtful Sales returns Inventory asset Loan loss Other
Sign. allowancei,t accountsi,t allowancei,t allowancei,t allowancei,t allowancei,t allowancei,t
TREATi,t * POSTi,t + 1.142** -0.05 -0.007 -0.009 1.233** -0.009 -0.015
(2.09) (-0.34) (-0.14) (-0.31) (2.31) (-0.19) (-0.35)

Adj. R2 0.49 0.39 0.38 0.41 0.46 0.61 0.42

(Continued)

57
Panel D: Allowances Analysis Deferred tax asset allowance increase vs. decrease (n = 134, 62 Rotations)

Rotation Firms Non-Rotation Firms Difference

Percent Increase 62.90 45.83 17.07**
Percent Decrease 37.10 54.17 -17.07**

Panel E: Allowances Analysis Predicting an increase in the deferred tax asset allowance (n = 134, 62 Rotations)

Logit
Exp. I(Increase DTAi)
Sign Coeff. z-statistic
TREATi + 0.836** (2.02)

Pseudo R2 0.18

This table presents additional analyses in the subset of matched pairs for which the non-rotation firm has exactly the same auditor names copied in the pre-period (POST = 0) to the post-period
(POST = 1). Panel A presents logit and conditional logit regression results examining the effect of partner rotation on restatements, similar to the analysis in Table 4, and we include all control
variables. Conditional logit regressions are estimated using matched pairs as strata. Z-statistics are reported in parentheses below the coefficients. Panel B presents logit and conditional logit
regression results examining the effect of partner rotation on write-downs and special items, similar to the analysis in Table 5, and we include all control variables. Conditional logit regressions
are estimated using matched pairs as strata. Z-statistics are reported in parentheses below the coefficients. Panel C presents OLS regression results examining the effect of audit partner rotation
on valuation allowance and reserve accounts, similar to the analysis in Table 6 Panel A, and we include all control variables. Fixed effects are included for each matched pair. T-statistics are
reported in parentheses below the coefficients. Panel D, similar to the analysis in Table 6 Panel B, presents the percent of firms whose deferred tax asset allowance balances increase or decrease
from the pre-period (POST = 0) to the post-period (POST = 1), such that there is one observation per four-year period; observations without deferred tax assets are excluded. T-tests for difference
in means are presented in the Difference column. Panel E, similar to the analysis in Table 6 Panel C, including all control variables, presents logit regression results predicting an indicator
variable which is equal to 1 when the mean Deferred tax asset allowance increases from the pre-period (POST = 0) to the post-period (POST = 1), and 0 otherwise, such that there is one
observation per four-year period; observations without deferred tax assets are excluded. Z-statistics are reported in parentheses to the right of the coefficients. The "Exp. Sign" columns indicate
"+" where we hypothesize the coefficient to be positive and "-" where we hypothesize the coefficient to be negative. N reports the number of firm-year observations. *, **, *** indicate
significance at the 0.10, 0.05, and 0.01 levels, respectively, using two-tailed p-values. Refer to Appendix A for variable definitions.

58