The effect of auditor tenure on the disclosure of restatements and material internal control weaknesses

Abstract

Objectives of the study This study investigates the association between audit firm tenure and announcement of financial restatements and material internal control weaknesses. These announcements are used as a proxy for auditor’s ability to find problems and misstatements, which is a different approach for studying audit quality compared to the most of the previous studies of audit quality. Motivation behind this study is the recent adoption of mandatory audit firm rotation in EU, and on other the other hand the majority of previous studies suggesting that audit quality improves with the tenure of audit firm. Also the reluctance of US firms to adopt mandatory audit firm rotation in the United States motivates this study.

Data and methodology The main sample of this study consists of 8541 firm-year observations from years 2004-2016. The sample data has been compiled from Audit Analytics and Compustat databases and has been analysed with two logistic regression models to find out possible associations between audit firm tenure and financial restatements or material internal control weakness disclosures.

Results The results from both of the regression models show that there is a significant positive association between short audit firm tenures and restatement or material internal control weakness disclosures. Specifically, auditor tenure of 0-1 years seems to be associated with financial restatement announcements and tenures 0-5 years with material internal control weakness disclosures. Also in the material internal control weakness model the tenure of 0-1 years has the highest regression coefficient indicating that problems are most likely to be disclosed right after audit firm change.