Audit Firm Tenure and the Equity Risk Premium

Abstract

Although investor perceptions of audit quality play a critical role in maintaining systemic confidence in the integrity of financial accounting reports (Levitt [2000]), prior research on the effects of auditor tenure from an investor perspective is relatively sparse. In this study, we investigate whether investors price audit firm tenure for Big Five audits by examining the relation between tenure and the ex ante equity risk premium, that is, the excess of the company-specific ex ante cost of equity capital over the risk-free interest rate. Based on prior research, whereas the “auditor learning” argument predicts that audit quality will change in only one direction (i.e., improve) with tenure, the “auditor-client closeness” argument suggests that audit quality may decrease beyond some (albeit unspecified) length of tenure because of impaired auditor independence and objectivity. Consistent with prior theoretical arguments, we find some evidence of a nonlinear relation between audit firm tenure and the ex ante equity risk premium, that is, we find that the equity risk premium decreases in the early years of tenure but increases with additional years of tenure. These findings persist after we control for well-known risk factors and company characteristics that have been shown in prior research to be related to the cost of equity capital. The implications of our findings are discussed.