Auditor Tenure and Audit Quality

I propose that audit quality is likely to increase with audit firm tenure due to a Learning Effect and decrease with audit firm tenure due to a Bonding Effect. The net impact of these two countervailing forces over audit firm tenure dictates whether the relationship between audit firm tenure and audit quality is a concave, convex, or linear function of audit firm tenure. When the Bonding Effect dominates the Learning Effect in the later (earlier) years of tenure, then audit quality is a concave (convex) function of audit firm tenure. Adopting the quadratic model to empirically estimate the audit firm tenure year when audit quality is likely to decline, I first find that the average point when audit quality optimizes is 12 years for a large sample of U.S. firms. Then I investigate how this turning point of audit quality is affected by auditors incentives to counter the negative impact from the Bonding Effect. Consistent with the notion that the Bonding Effect is less severe for high quality auditors, I find that the turning point of audit quality is longer for firms with Big N auditors, specialist auditors, and auditors of high client importance. In the additional analyses, I further examine how the turning point of audit quality varies over time and across industries. I find that, since Sarbanes-Oxley Act of 2002 (SOX, hereafter) was enacted, the turning point gets longer, implying that SOX may have mitigated the Bonding Effect. Moreover, I find that the deterioration of audit quality for extended auditor tenure only exists in low-litigation industries but not in high-litigation industries, suggesting that the incentives argument rather than the cognitive bias argument prevails in explaining the Bonding Effect. My results have implications for the current debate on whether audit firm rotation should be mandatory for the U.S. companies.