Audit Firm Tenure and the Equity Risk Premium

Journal of Accounting Auditing and Finance, Vol. 23, No. 1, pp. 115-140, Winter 2008

Posted: 26 Oct 2006 Last revised: 16 Jun 2010

See all articles by Jeff P. Boone

Jeff P. Boone

University of Texas at San Antonio - Department of Accounting

Inder K. Khurana

University of Missouri at Columbia - Robert J. Trulaske, Sr. College of Business

K. K. Raman

The University of Texas at San Antonio

Date Written: June 16, 2010

Abstract

Although investor perceptions of audit quality play a critical role in maintaining systemic confidence in the integrity of financial accounting reports (Levitt 2000), prior research on the effects of auditor tenure from an investor perspective is relatively sparse. In this study, we investigate whether investors price audit firm tenure for Big Five audits by examining the relation between tenure and the ex ante equity risk premium, i.e., the excess of the company-specific ex ante cost of equity capital over the risk-free interest rate. Based on prior research, whereas the "auditor learning" argument predicts that audit quality will change in only one direction (i.e., improve) with tenure, the "auditor-client closeness" argument suggests that audit quality may decrease beyond some (albeit unspecified) length of tenure due to impaired auditor independence and objectivity. Consistent with prior theoretical arguments, we find some evidence of a non-linear relation between audit firm tenure and the ex ante equity risk premium, i.e., we find that the equity risk premium decreases in the early years of tenure but increases with additional years of tenure. These findings persist after we control for well-known risk factors and company characteristics that have been shown in prior research to be related to the cost of equity capital. The implications of our findings are discussed.

Keywords: Audit firm tenure, Perceived audit quality, Cost of equity capital

Suggested Citation

Boone, Jeff P. and Khurana, Inder and Raman, K. K., Audit Firm Tenure and the Equity Risk Premium (June 16, 2010). Journal of Accounting Auditing and Finance, Vol. 23, No. 1, pp. 115-140, Winter 2008. Available at SSRN: https://ssrn.com/abstract=940401

Jeff P. Boone (Contact Author)

University of Texas at San Antonio - Department of Accounting ( email )

One UTSA Circle
San Antonio, TX 78249
United States

Inder Khurana

University of Missouri at Columbia - Robert J. Trulaske, Sr. College of Business ( email )

331 Cornell Hall
Columbia, MO 65211
United States
573-882-3474 (Phone)
573-882-2437 (Fax)

K. K. Raman

The University of Texas at San Antonio ( email )

One UTSA Circle
San Antonio, TX 78249
United States
210-458-8749 (Phone)

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