The study, by Professors Zvi Singer of HEC Montreal and Jing Zhang of the University of Alabama, casts doubt that audit-partner rotation, as mandated in the US by Sarbanes-Oxley, is a sufficient substitute for audit-firm rotation. Although the legislation reduced the negative effect of lengthy tenure by about 50%, the effect has remained significant.

As for the EU’s mandate that companies seek offers from other accounting firms after 10 years of auditor tenure, the study found that 10 years is about the point where the ill effects of long tenure recede.

The professors stated: ‘Beyond 10 years of auditor tenure, the association between auditor tenure and misstatement duration is insignificant. The benefits of a fresh look exist only in the first 10 years of the auditor-client relationship.’

Previous studies have suggested that short auditor tenure leads to low financial-reporting quality because the new auditor lacks the client-specific knowledge accumulated over time. However, the professors argue an alternative interpretation is that low financial-reporting quality leads to short auditor tenure, because the auditor and the client are more likely to run into disagreements when the firm’s own financial reporting quality is low.

Methodology

To test out this out, the research focused on serious accounting errors that occur and are corrected during the tenure of the same auditor. Looking at data involving 3,465 corporate misstatements by US companies during a 14-year period, the academics investigated how length of tenure affects auditors’ speed in coping with misstatements.

In about 35% of these cases, misreporting occurred in only a quarterly statement but not in the subsequent annual financial report, suggesting auditor vigilance and high audit quality. However, in the remaining instances, misstatements occurred in one, two, or more annual reports that auditors signed off on, with longer duration signaling lesser auditor vigilance and lower audit quality.

When auditor tenure was three years or less, the average misstatement duration was a little less than a year, whereas when it was 11 or more years, average duration was about a year and a half, more than 50% greater.

Further evidence of the impact on auditing of a fresh view came from analysis of a group of companies forced to change an external auditor, because of the collapse of the accounting firm Arthur Andersen.

The professors focused on accounting misstatements that started under Andersen and ended after the forced switch to another auditor. Comparing the duration of those misstatements with those of companies that retained a single Big-Four auditor over that same span, the professors find that the latter lasted on average 15% longer, a statistically significant difference.

To assess the EU rotation mandate, the academics divided the 3,465 companies in their primary sample between those that retained their audit firm for up to 10 years and those that retained them longer.

Up until 10 years, the study found ‘a one-year increase in auditor tenure increases the misstatement duration by approximately 2.02% [so that] on average, misstatements are 18.18% longer after 10 years of auditor tenure than after one year.’

‘Beyond 10 years of auditor tenure, the association between auditor tenure and misstatement duration is insignificant. In conclusion, the benefits of a fresh look exist only in the first 10 years of the auditor-client relationship.’

The conclusion of the research is that the results support concerns raised by the Public Company Accounting Oversight Board (PCAOB) that long auditor tenure may lead to impairment of auditor independence due to the development of a strong bond with the client over time, and as a result may compromise audit quality.

The study, entitled Auditing Tenure and the Timeliness of Misstatement Discovery, is in the March issue of The Accounting Review, published by the American Accounting Association.

Report by Pat Sweet