Auditor Tenure and Misreporting: Evidence from a Dynamic Oligopoly Game

Abstract

We estimate an infinite-horizon dynamic oligopoly model of audit firm tenure and misstatements and evaluate a policy counterfactual involving mandatory audit firm rotation. Longer tenure lowers the cost of producing audits, increasing audit quality and reducing audit fees. Thus clients are less likely to misstate and more likely to keep the incumbent audit firm as tenure increases. By reducing the value of retaining audit firms, mandatory rotation leads to large increases in auditor switches, even before the term limit, implying increases in the switching costs borne by clients. Misstatement rates increase because audit firms endogenously lower audit quality and newly hired audit firms have lower quality. Overall, the model suggests caution when evaluating the costs and benefits of government oversight over the audit profession. This paper was accepted by Suraj Srinivasan, accounting. Funding: The authors thank the financial support from the Olin Busiiness School and the Wharton School of the University of Pennsylvania. Supplemental Material: The online appendix and data files are available at https://doi.org/10.1287/mnsc.2023.4944 .