Audit Firm Tenure, Non‐Audit Services, and Internal Assessments of Audit Quality

• Author: MONIKA CAUSHOLLI,W. ROBERT KNECHEL,TIMOTHY B. BELL
• DOI: http://doi.org/10.1111/1475-679X.12078
• Published date: 01 June 2015
• Date: 01 June 2015

DOI: 10.1111/1475-679X.12078

Journal of Accounting Research

Vol. 53 No. 3 June 2015

Printed in U.S.A.

Audit Firm Tenure, Non-Audit

Services, and Internal Assessments

of Audit Quality

TIMOTHY B. BELL,

∗MONIKA CAUSHOLLI,

†

AND W. ROBERT KNECHEL

‡

Received 22 October 2012; accepted 24 February 2015

ABSTRACT

We use data from internal assessments of audit quality in a Big 4 firm to

investigate the impact of audit firm tenure and auditor-provided non-audit

∗Coggin College of Business, University of North Florida, Jacksonville; †Von Allmen School

of Accountancy, University of Kentucky; ‡Fisher School of Accounting, University of Florida.

Accepted by Christian Leuz. The data set used in this research was obtained from a large

international accounting firm by one of the authors who was employed by the firm at the

time the data were collected. The author developed a questionnaire to gather information

during the reviews on various audit fee, production, and other engagement characteristics.

The author was not involved in the sampling or data gathering process and gained access

to the data in October of 2003 in order to pursue academic research. At that time, the au-

thor was given verbal assurances that the data are complete and unmodified. This author has

not been employed by the firm for over six years in any capacity and the other two authors

have no financial or other links to the firm. The research team is obligated under nondis-

closure restrictions “not to disclose the confidential information (defined as all of the data

contained in the data set) to any third party” and “not to identify the firm or any of its part-

ners, principals, employees, or clients in any article or presentation.” No other restrictions

were imposed by the firm on the use of the data, the conduct of the current research, or

the communication of the research findings. We thank the personnel from the firm for their

assistance and support for the project and an anonymous reviewer for very valuable input.

We also would like to thank Robert Ramsay, Dan Stone, workshop participants at the Univer-

sity of Auckland, University of Kentucky, Miami University at Ohio, Monash University, KU

Leuven, and Boston College as well as participants at the 2011 International Symposium on

Audit Research (ISAR), 2012 Auditing Midyear Meeting, 2012 University of Oklahoma Con-

ference on Regulation and the Audit Industry, 2012 Asia-Pacific Conference on International

Accounting Issues, and the 2013 Accounting and Finance Association of Australia and New

Zealand (AFAANZ Conference). An online appendix to this paper can be downloaded at

http://research.chicagobooth.edu/arc/journal-of-accounting-research/online-supplements.

461

Copyright C, University of Chicago on behalf of the Accounting Research Center,2015

462 T.B.BELL,M.CAUSHOLLI,AND W.R.KNECHEL

services (NAS) on audit quality. We find that first-year audits receive lower

assessments of audit quality and that quality improves shortly thereafter and

then declines as tenure becomes very long. Partitioning our sample between

SEC registrants and private clients, we find that the decline in audit quality in

the long tenure range is attributable to audits of private clients. For audits of

SEC registrants, the probability of a high quality audit reaches its maximum

with very long tenure. We also find that audit fees are discounted for first-

year audits but auditor effort is higher than in subsequent years. We find no

association, on average, between total NAS fees and audit quality in the full

sample but observe that total NAS fees are positively associated with quality

for SEC registrants and negatively associated with quality for privately held

clients. Our findings are important for regulatory policies related to audit

firm tenure and auditor-provided NAS.

JEL codes: M40; M41; G18; L84

Keywords: audit quality; audit firm tenure; non-audit services

1. Introduction

After decades of debate and research, the auditing profession, regulators,

and researchers continue to wrestle with two longstanding concerns about

perceived threats to auditor independence and audit quality: (1) social

bonding—becoming personally friendly with, or increasingly trusting of,

client management, and (2) economic bonding—becoming financially de-

pendent on multiperiod fees from audits and non-audit services (NAS) pro-

vided to the client. Regulators have argued that social bonding from long

tenure erodes professional skepticism and induces auditor complacency,

while economic bonding from non-audit fees prompts auditor concessions

or shirking in response to management’s financial reporting demands.1On

the other hand, the auditing profession has argued that there is no systemic

decline in audit quality as audit firm tenure or fees from NAS increase,

and that restrictions on tenure or NAS disrupt auditor learning, constrain

the financial and human resources available for audit production, and

impede knowledge spillovers. The financial crisis of 2008 reignited debate

on these issues (see, e.g., European Commission [2010, 2011], PCAOB

[2011]). In 2014, the European Parliament issued new regulations on both

mandatory audit firm rotation and NAS (European Parliament, Council

of the European Union [2014]). This study examines the impact of audit

firm tenure and auditor-provided NAS on audit quality using unique

quality measures derived from a large international audit firm’s internal

assessments of its audit process for a sample of 265 U.S. audit engagements.

1Regulators have also argued that auditor provision of certain types of NAS, for example,

services involving bookkeeping, financial information systems design and implementation,

appraisals and valuations, and internal audit outsourcing, compromise independence. In

2000, the SEC adopted a ban on auditor provision of these NAS services (SEC [2000]), later

extended by the Sarbanes-Oxley Act of 2002.

AUDIT FIRM TENURE,NON-AUDIT SERVICES,AUDIT QUALITY 463

The effects of auditor tenure and NAS on audit quality have been exten-

sively examined in prior research. Most of the research on auditor tenure

finds evidence of a positive association between tenure and quality (Myers,

Myers, and Omer [2003]), while a small number of studies find evidence of

a negative (Cahan and Zhang [2006]) or nonlinear (Brooks, Cheng, and

Reichelt [2013]) association. Results in studies of the association between

NAS and audit quality are even more diverse with evidence suggesting

no association (Ashbaugh, Lafond, and Mayhew [2003]), a negative asso-

ciation (Frankel, Johnson, and Nelson [2002]), or a positive association

(Davis, Soo, and Trompeter [2009]). A possible reason for these mixed

findings is that researchers have had to use externally observable proxies

for audit quality, such as abnormal accruals, accounting restatements,

going concern opinions, or meet/beat analyst forecasts. While useful,

these proxies are indirect audit quality measures pertaining to different

types of financial reporting and other audit-related outcomes that may

not fully reflect the quality of auditors’ execution of the audit process. For

example, proxies for abnormal accruals represent audit quality as a strictly

decreasing function of the deviation (or absolute deviation) of an entity’s

accruals from their respective industry averages. However, the PCAOB has

noted that they “have found no direct statistical relationship between the

size of an abnormal accrual and the probability that inspections staff would

detect an audit failure” (PCAOB [2011, p. 37]).2Similarly, restatement

metrics do not differentiate audits that comply with auditing standards

from noncompliant audits.3Finally, going-concern proxies and indicators

of meet/beat analyst forecasts are measures of ex post outcomes that might

not fully reflect the aspects of the audit process that are of greatest concern

to internal reviewers and external inspectors.

In contrast to these outcome proxies, regulators and internal reviewers

focus primarily on two complementary process-related characteristics

when making direct assessments of audit quality: (1) the extent and

appropriateness of evidence supporting the auditor’s opinion and (2) the

degree of correspondence between the auditor’s procedures and auditing

standards (Hansen [2014]). As a result, inspectors may judge some audits

that have (or will have) external proxies indicating poor audit quality (e.g.,

high accruals) to be acceptable based on more direct evidence from the

audit process. Similarly, there may be instances where external proxies

2Schelleman and Knechel [2010] provide evidence suggesting that the quantity and quality

of audit evidence obtained by auditors increase with the magnitude of accruals.

3Consistent with this perspective, Palmrose and Scholz [2004] find that, in a sample of

492 restatements, 185 (38%) of the restating entities were involved in litigation related to

the restatements, but auditors were included as defendants in only 65 (35%) of the 185 legal

actions. Also, the SEC issued Accounting and Auditing Enforcement Releases in only 63 (13%)

of the 492 restatement cases.