Audit Tenure and the Timeliness of Misstatement Discovery

Zvi Singer is associate professor of accounting at HEC Montreal, and Jing Zhang is assistant professor of accounting at the University of Alabama in Huntsville. This post is based on their recent article, published in The Accounting Review.

Is long auditor tenure beneficial or detrimental for audit quality? This is the question we are trying to address in this article. The impact of audit firm tenure and auditor rotation on audit quality have long been debated both within academia and by regulators in the US and globally. The debate has centered on two main opposing views. The positive view argues that longer auditor tenure leads to a higher quality audit via a learning effect, due to the accumulation of client-specific knowledge over time. An auditor that is more knowledgeable of the client is more likely to promptly identify financial reporting problems. Accordingly, regulatory intervention that limits the length of the auditor-client engagement is undesirable. The negative view argues that long auditor tenure may have a detrimental effect on audit quality for two reasons. First, long auditor tenure may lead to the development of economic and social bonds between the auditor and the client company due to continuous involvement. This, in turn, has the potential to impair the auditor’s objectivity and increase the likelihood of audit failure. Second, because the audit is performed year in and year out, the auditor may become complacent, due to the repetitive nature of the task. A complacent auditor, in turn, may fail to promptly detect misreporting, leading to audit failure. In contrast, a new auditor would bring a fresh viewpoint, which will benefit the audit engagement. Consequently, under the negative view, it is desirable to limit the length of the auditor-client engagement.

For the most part, academic research on the effect of auditor tenure on audit quality shows evidence consistent with the positive view. Nonetheless, regulators continue to express concern about the negative effect of long auditor tenure on audit quality and have tightened regulations related to both audit firm tenure and audit partner tenure. In 2002, the Sarbanes-Oxley Act (SOX) accelerated the audit partner rotation period from seven to five years and expanded the cooling-off period from two to five years. Other countries have also introduced similar, or even stricter legislation. In 2014, the European Union passed regulations mandating audit firm rotation after ten years. In the US, the Public Company Accounting Oversight Board (PCAOB) tried to pass similar regulations, but was blocked by Congress in 2013.

A major limitation of prior studies that examine the effect of auditor tenure on audit quality is that in their research design, auditor tenure is endogenous. This is because companies with lower financial reporting quality may replace their auditors more often than other companies due to disagreements; as a result, their auditors will have shorter tenure. This makes causal inference problematic. Most of these studies find a positive association between auditor tenure and financial reporting quality and conclude that short auditor tenure is detrimental to audit quality. However, because of the endogeneity problem, an alternative interpretation of these findings is that lower financial reporting quality leads to shorter auditor tenure. We address the endogeneity problem by examining the effect of auditor tenure on the timeliness of misstatement discovery. To account for the timeliness of the discovery, we use the length of the misstatement. We measure auditor tenure from the first year of the audit engagement up to the year the misstatement began, and we measure misstatement duration from the year that the misstatement began to the year it ended. In this setting, auditor tenure is predetermined at the onset of the misstatement period, and therefore unlikely to be endogenous to the misstatement duration. As a result, our examination avoids the issue of reverse causality, the possibility that misstatement duration affects auditor tenure.

We find a positive association between auditor tenure and misstatement duration, implying a negative association between auditor tenure and timeliness of misstatement discovery. In other words, auditors with shorter tenures are faster to discover financial misreporting. This is consistent with a negative effect of long auditor tenure on audit quality. Economically, we find that compared with companies with medium auditor tenure, misstatements of companies with short auditor tenure are approximately 9.4 percent shorter and those of companies with long auditor tenure are 6.4 percent longer.

To assess the importance of a fresh view by a new auditor, we use the demise of Arthur Andersen in 2002 to examine whether a newly appointed auditor discovers misreporting more promptly than an incumbent auditor. The advantage of using this exogenous event is that the replacement of Andersen by a new auditor was non-voluntary and, therefore, was not affected by the client`s financial reporting quality. We identify a group of Andersen clients who had accounting misstatements starting in 2000 or 2001 and ending after Andersen’s clients switched to another auditor in 2002. We match those companies with comparable companies that also had misstatements that started at the same time, but retained the same auditor throughout the misstatement. We find that the former Andersen clients had significantly shorter misstatement duration (i.e., ended earlier) than the control companies. This suggests that the incumbent auditors were slower in detecting the misreporting, which speaks to the benefit of a fresh view by a new auditor. This result complements our finding of a positive association between auditor tenure and misstatement duration, thus providing support to our argument that long auditor tenure impairs audit quality.

Our findings should be of interest to regulators and the long-standing debate regarding the costs and benefits of mandatory audit firm rotation. Our results support the PCAOB’s concern that long auditor tenure impairs audit quality. The timely discovery of misstatements by an auditor is of great importance to companies and market investors, not only because it prevents misstatements from exacerbating, but also because it helps investors to promptly adjust their valuation, resulting in a lower likelihood of extreme stock price volatility and stock price crashes. While our study focuses on the effect of auditor tenure on the timeliness of misstatement discovery, future studies can examine other determinants of misstatement duration.

The complete article is available for download here.

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