Auditor Tenure and Perceived Earnings Quality

Date01 November 2016
DOIhttp://doi.org/10.1111/ijau.12069
Published date01 November 2016
Auditor Tenure and Perceived Earnings Quality
Daniela Hohenfels
Darmstadt Uni versity of Technology
The study examines how auditor tenure affects investorsperception of audit quality. It is motivated by the ongoing
debate on the effect of auditor tenure on audit quality and the recent regulation approval on mandatory auditor
rotation at the EU level, which is justified by the concern that longer auditor tenure impairs auditor independence
and thus lowers audit quality. Perceived earnings quality, as measured by the earnings response coefficient from
returns-earnings regression, is used as a proxy for investorsperception of audit quality. Using a sample of 2,320
firm-year observations from German listed firms between 2006 and 2013, the study provides evidence of a non-
linear relationship between auditor tenure andperceived earnings quality. The results suggestthat investors perceive
lower earnings quality during the early and later years of an auditorclient relationship. This perception does not
change during the investigation period. Furthermore, the results show that earnings quality is perceived as highest
when auditor tenure is 89years.
Key words: Auditor tenure,perceived audit quality, investors, audit firm rotation, earnings quality, earnings response
coefficient, Germany
1. INTRODUCTION
The topic of whether auditquality is affected by the length
of an auditorclient relationship is nothing new. Instead,
the debate on the effectsof auditor tenure on audit quality
has continued for more than 50 years (e.g., Mautz & Sharaf,
1961). However, it was intensified after accounting scandals
during thepast 20 years, which werecharacterized bycases
of fraud(Enron, Worldcom, Parmalat,Holzmann, Siemens),
and the financial crisis which has led to the re-emergence of
public concerns about the credibility of audited financial
statements.A predominantstatement of financial statement
users is thatthe auditor couldhamper such situations,if the
financial statement is accurately audited. On the one hand,
such statements are attributed to an existing expectation
gap between financial statement users and the audit
profession related to the auditorsresponsibilities, which
means that financial statement users assume a broader
scope than auditors actually have. For example, financial
statement users often associate audits and an unqualified
audit opinion with a guarantee of the absence of fraud or
as a recommendation for investment (Frank, Lowe & Smith,
2001). On the other hand, such events intensify doubts on
whether audit quality is at an appropriate level and thus
diminishes public trust in an audit.
Regulatory efforts at the EU level subsequent to the
financial crisisto bolster the credibility of audited financial
statements and to enhance audit quality also identified the
length of an auditorclient relationship as an important
factor that impairs audit quality. Firms involved in
accounting scandals are often characterized by a long
auditor tenure.
1
The related Green Paper of the EU
Commission refers to a survey on the length of auditor
client relationships where more than halfof the respondent
firms reported that their auditor had served the company
for more than 7 years and 31 percent reported that an
auditor change had not occurred for more than 15 years
(European Commission, 2010). It is stated that auditors
become overly familiar with the management of the firm
with longer auditortenure, which diminishes the auditors
professional skepticism.
In April 2014, the EU Parliament approved a regulation
that requires a limitation on the duration of an auditorclient
relationship (EU Parliament, 2014). Article 17 (1) of this
regulation imposes a maximum length of auditorclient
relationship of 10 years for firms of public interest. The
maximum duration can be extended to 20 years, where a
public tendering process for the statutory audit is conducted
(Art.17(4a)),orto24years,wheremorethanoneauditoris
simultaneously engaged (jointaudit)(Art.17(4b)).Each
member state had to decide on how to concretely implement
the new EU regulation in national law by 17 June 2016. The
German legislator adopted the EU requirements (Paragraph
318 (1a) German Commercial Code). Regarding EU member
states, a mandatory auditor rotation only existed in Italy
for firms of public interest before. In Poland and Slovenia,
a mandatory auditor rotation rule existed for insurance
firms and additionally in Slovenia for investment firms.
The rotation cycle varied between 5 and 7 years. Greece,
Latvia, Spain, the Czech Republic and Austria scrapped
the auditor rotation rule, partially before the rule became
effective or previously to the end of the first rotation cycle
(Deloitte, 2012). In Germany and in most other EU
member states only an audit partner rotation was
required so far.
2
This study capt ures the recent regulati on requirement on
auditor rotation and analyzes how investorsperception of
audit quality is affected by auditor tenure. The results allow
for inferences on the advantages of an auditor rotation rule
from the viewpoint of this group of financial statement users.
The study analyzes the perception of investors, as they are
one of the main addressees of financial statements. Investors
are an important part of the resource allocation process as
they provide the firms equity capital and their investment
decisions consider reported financial information. Therefore,
less credibility in financial information could have
substantial consequences for capital markets, as investors
could implicitly assume incorrect financial information
reported by the firm and therefore perceive a high
information risk, which in turn could lower their investment
activities (Watts & Zimmermann, 1986).
An archival study is conducted to analyze investors
perception of audit quality. Because audit quality is not
Correspondence to: Dr. Daniela Hohenfels, Darmstadt University of
Technology, Hochschulstraße 1, 64289 Darmstadt, Germany. Email:
hohenfels@bwl.tu-darmstadt.de
International Journal of Auditing doi: 10.1111/ijau.12069
Int. J. Audit. 20:224238 (2016)
©2016 John Wiley& Sons Ltd ISSN 1090-6738

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