New study says long audit tenure slows corrections

Recently published academic research suggests there is indeed a detriment to audit quality when audit firms hold long tenures on audit engagements.

“We find that longer audit firm tenure leads to less timely discovery and correction of misstatements, which is consistent with a negative effect of long auditor tenure on audit quality,” write authors Zvi Singer of HEC Montreal and Jing Zhang of the University of Alabama in Huntsville. “This finding speaks to the benefit of a fresh look by a new auditor.”

The study is based on the timeliness of the discoveries of errors in financial statements, comparing audits performed by relatively newer auditors against auditors that have served for long periods on the same engagements.

The research uses data produced by the massive turnover in audit engagements that occurred when public companies fled Arthur Anderson in 2002 as it crumbled under the Enron scandal. The analysis determined misstatements of former Arthur Andersen clients were discovered and corrected faster than those of comparable companies who retained the same audit firm through a misstatement.

The analysis also concludes longer auditor tenures lead to bigger misstatements. And it identifies 10 years as the sweet spot for tenure. "Beyond 10 years of auditor tenure, the association between auditor tenure and misstatement duration is insignificant,” the authors wrote. “The benefits of a fresh look exist only in the first 10 years of the auditor-client relationship."

The debate over auditor tenure has long rested on some key arguments for and against long-standing relationships. Opponents of audit firm rotation say long-standing relationships produce institutional knowledge at audit firms that makes the audit more meaningful and efficient. Proponents say such long-standing relationships lead to personal ties that cloud judgment, which a fresh set of eyes can overcome.

The study, which appears in the academic journal of the American Accounting Association, takes a more skeptical view of long-standing relationships than capital markets currently hold, where long auditor tenures are associated with lower corporate borrowing costs, enhanced responses to earnings reports, and higher stock ratings. Prior studies have concluded, the authors say, that short tenure leads to lower financial reporting quality. An alternate view, they assert, is that low financial reporting quality leads to short auditor tenure because disagreements are more likely.

The study tries to control for that uncertainty over cause and effect by focusing on serious accounting errors that occur or are corrected during the tenure of the same auditor. The data is based on nearly 3,500 misstatements reported by U.S. companies over 14 years.

Sarbanes-Oxley attempted to address concerns about long auditor tenures — breaking up the cozy ties between management and auditor that former over long-standing relationships — by requiring audit firms to rotate engagement partners on all public company audit engagements every five years. Driven by its former chairman, James Doty, the Public Company Accounting Oversight Board explored whether to set term limits on audit engagements, but failed to gain support for such a move, even among board members. Even the House of Representatives joined the protest, passing legislation to prohibit the PCAOB from establishing any kind of mandatory rotation system.