Audit Firm Tenure, Bank Complexity and Financial Reporting Quality

Abstract

Theory from organizations and economics research posits that in an inter-organizational exchange relationship, learning leads to relationship-specific investments that facilitate the effectiveness of the relationship while strengthening the attachment between the exchange parties. In complex settings where the opportunities for learning are greater, the investments will be larger and the attachment stronger. Because banks are complex institutions that present unique challenges to auditors, we argue that an effective audit critically depends on the accumulation of significant investments in client-specific expertise through a long association with the client. Thus, we expect that in banks a long audit firm tenure is positively associated with financial reporting quality and we expect this association to be particularly strong in more complex banks. Our findings are consistent with these expectations. In addition, contrary to prior research we find that benefits to a long tenure for complex banks accrue even for very long tenures and are not limited to intermediate tenures. Our findings largely support the notion that a long association with the client reflects the underlying demand for expertise, which is critical for the delivery of high quality audits in complex organizations. Imposing short-term limits on auditors would adversely impact the investments in client-specific expertise especially in the cases where this expertise is needed the most. Our findings do not support calls for imposing mandatory rotation of auditors among large complex institutions.