The Auditor-to-Client Revolving Door and Earnings Management

Abstract

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