Audit Firm Tenure and Nonprofessional Investors' Perceptions of Entitativity and Independence Impairment: The Mitigating Effect of Partner Rotation Disclosure

Abstract

In 2017 the PCAOB began requiring audit firm tenure disclosure within the audit report for SEC registrant clients. Many commenters raised concern that prominent disclosure of firm tenure in the audit report will lead investors to inappropriately infer a negative relationship between audit quality and long firm tenure. This is particularly troubling given that empirical evidence generally does not support this concern. Using psychology research on entitativity (a cognitive process through which individuals attribute varying degrees of interconnectedness among others), we predict and find disclosing an audit firm’s long tenure within the audit report increases investors’ perceptions of entitativity between the audit firm and client, and thus reduces investors’ beliefs that the auditor was independent while conducting the audit. We also identify a treatment to mitigate the effects of reporting long firm tenure—disclosure of a firm’s adherence to the SEC’s mandatory partner rotation requirement. Specifically, partner rotation disclosure moderates the mediation of firm tenure on investors’ judgments such that the indirect effect through entitativity operates only when partner rotation is not disclosed in the auditor’s report. Our results should be useful to regulators in understanding one effect of their standard, and to audit firms because of their autonomy over adding engagement partner rotation protocols to their audit reports and potentially mitigating the effect of firm tenure disclosure.