Audit Firms Tenure and Investors’ Perceptions of Audit Quality
This study analyzes how investors perceive of audit firms1 tenure. Using earnings response coefficients from returns-earnings regressions as a proxy for investor perceptions of earnings quality, the results document a positive association between investor perceptions of earnings quality and tenure. Further, this study finds that the association between debt ratings and reported earnings does not vary with tenure. Finally, the result shows that the influence of past earnings on one-year-ahead earnings forecasts becomes larger as tenure increases. In general, the results are consistent with the hypothesis that investors perceive auditor tenure as improving audit quality. One implication of this study is that imposing mandatory limits on the duration of the auditor-client relationship might impose unintended costs on capital market participants.
Keywords: audit firms tenure; auditor independence; audit quality; earnings quality; mandatory auditor rotation; capital market perceptions.
The recent rise in accounting irregularities has reopened questions about auditor tenure, independence, and audit quality (Bricker, 2002; Mayangsari, 2005). Recent studies provide valuable insights into the debate surrounding auditor tenure by examining the association between tenure and (1) accounting accruals, (2) analysts’ forecast errors, and (3) the cost of debt. Myers et al. (2003) conclude that longer auditor tenure constrains managerial discretion with accounting accruals, which suggests high audit quality. Johnson et al. (2002) also find that accruals are larger and less persistent for firms with short auditor tenure relative to those with medium or long tenure.
Using credit spreads between bond yields and matched Treasury yields as the cost of debt, Mansi et al. (2004) find that the cost of debt declines with longer tenure, which suggests bondholders perceive audit quality as improving with extended tenure. In contrast, Davis et al. (2002) conclude that audit quality declines with extended tenure because, as tenure increases, client firms have greater reporting flexibility and earnings forecast errors decline. Mayangsari (2005) finds that lawsuit against auditor positively is influenced by auditor tenure for Indonesia case.
This study focuses on how investors perceive auditor tenure. Using earnings response coefficients from returns-earnings regressions as a proxy for investor perceptions of earnings quality, I analyze whether investors perceive earnings quality as being affected by tenure. Specifically, I examine whether tenure affects the relationship between reported earnings and debt ratings.