Audit Firm Tenure and Audit Quality: Evidence from U.S. Firms

Abstract:     
PCAOB recently solicits comments on a 10-year mandatory audit firm rotation for the largest 100 S&P firms. We propose that audit quality is likely to increase with audit firm tenure due to a dominant Learning Effect in earlier years and decrease with audit firm tenure due to a dominant Bonding Effect in later years. Adopting a quadratic model to empirically estimate the firm tenure year when audit quality is likely to decline, we find that the average point when audit quality optimizes is 12 years for a large sample of U.S. firms. With an average tenure of 9 years only in our sample, these findings imply that mandatory auditor firm rotation may not be necessary. Further, we find that the negative impact of long tenure on audit quality is driven by non-Big N auditors, non-specialist auditors, and auditors with high client importance, consistent with the Bonding Effect explanation. Moreover, we find that after Sarbanes-Oxley Act of 2002 (SOX, hereafter) was enacted, the turning point gets longer, implying that SOX may have mitigated the Bonding Effect. Our results have implications for the current debate on whether audit firm rotation should be mandatory for the U.S. companies.

Number of Pages in PDF File: 64

Keywords: audit firm tenure, audit quality, term limit, turning point, and mandatory audit firm rotation

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