chu et al - 2012 - does long tenure erode auditor independence

Does Long Tenure Erode Auditor Independence?
Ling Chu

School of Business and Economics
Wilfrid Laurier University
Waterloo, ON
N2L 3C5



Bryan K. Church

800 West Peachtree Street
College of Management
Georgia Tech
Atlanta, GA 30308-0520
404.894.3907



Ping Zhang

Rotman School of Management
University of Toronto
Toronto, ON M5S 3E6
416-946-5655

January 2012

2

Does Long Tenure Erode Auditor Independence?
Abstract
Regulators have shown a renewed interest in considering the merits of mandatory auditor
rotation. A fundamental concern is that long tenure may undermine auditor independence. We
conduct a study to investigate the effects of long tenure on companies’ allowance for bad debts
(ABD). We focus on ABD, as opposed to total accruals, because it allows us to hone in on the
effect of auditor tenure on a specific accrual. By examining ABD, we are able to conduct a more
direct and powerful test and avoid some of the measurement error and noise associated with total
accruals (e.g., discretionary or abnormal). We find evidence of a negative association between
auditor tenure and estimated ABD. The finding holds across a series of robustness tests. Further
analyses suggest that long tenure (around 15 years) is associated with downward bias in
estimated ABD. With long tenure, the auditor endorses an estimate of ABD that is too
aggressive. This result is consistent with the argument that long tenure leads to compromised
independence. Our findings suggest that a term limit of 10 years, which has been suggested
elsewhere (e.g., PCAOB 2010; Chasan 2011), is sufficient to preserve auditor independence.

JEL classification: M41
Does Long Tenure Erode Auditor Independence?
1. Introduction
Regulators are once again considering the merits of mandatory audit firm rotation. Under
Section 207 of the Sarbanes-Oxley Act of 2002 (SOX), the Comptroller General of the United
States was directed to study the potential effects of requiring firm rotation. The General
Accounting Office (GAO) completed a report in the fall of 2003 and concluded that, in light of
other reforms enacted as a result of SOX, it was not cost beneficial to mandate audit firm rotation

(GAO 2003). But, the GAO’s report states that further experience is necessary to evaluate the
effect of other SOX reforms to gauge the implications for auditor independence and audit quality:
that is, to determine whether other SOX reforms are sufficient.
In the years since the GAO’s study, pundits (e.g., Sikka 2009; Rapoport 2010) have
claimed that auditors played a role in the global financial crisis, willingly turning a blind eye to
clients’ questionable accounting tactics (leading to inflated asset values). The PCAOB also has
gathered data through its inspection process, with inspection reports often suggesting that
auditors lacked sufficient professional skepticism (PCAOB 2008). Hence, regulators have a
renewed interest in taking actions to strengthen auditor independence.
On August 16, 2011, the Public Company Accounting Oversight Board (PCAOB) issued
Concept Release on Auditor Independence and Audit Firm Rotation, which revisits imposing
term limits on auditor-client relations. The Board is particularly interested in relationships that
extend beyond ten years (PCAOB 2011, 20). The European Commission (EC) also is actively
considering firm rotation and various proposals have suggested term limits of nine years and six
years (EC 2010; Barker and Hughes 2011; Journal of Accountancy 2011). With long tenure, the
auditor may face significant pressure to preserve client relationships, which may encourage the
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auditor to acquiesce to client demands, undermining independence. The practical implications of
such concerns cannot be underestimated. The average auditor tenure of the 500 (100) largest
companies in the U.S., based on market capitalization, is 21 (28) years (PCAOB 2011, 20).
1

Academic research has examined the association between auditor tenure and various
proxies for audit/financial reporting quality. Researchers have commonly used proxies based on
unexpected accruals (signed and unsigned), with the findings being decidedly mixed, particularly
with respect to long tenure. Some studies find that quality is not affected by long tenure (e.g.,
Johnson et al. 2002; Gul et al. 2007); others find that quality improves with long tenure (e.g.,
Myers et al. 2003; Srinidhi et al. 2010); and still others find that quality diminishes with long
tenure (e.g., Raghunathan 1994; Davis et al. 2009). The mixed findings may be attributable, in

part, to the measurement error inherent in estimating total accruals (see e.g., McNichols and
Wilson 1988; Healy and Wahlen 1999). A fundamental concern with unexpected accruals is that,
across a range of accounts, the potential for a noisy measure is magnified. Furthermore, if
unexpected accruals change over time, measurement error may be compounded due to the
reversing nature of accruals (Chu et al. 2011). In the current paper, we take a different approach
and focus on one specific accrual, companies’ allowance for bad debts (ABD). As compared to
total accruals, ABD is little affected by accounting estimates in prior periods: it is an offset to
accounts receivable (a current asset), and, thus, valuation issues (the accuracy of the accrual)
typically are resolved within a one-year time frame. Our approach permits a more precise
measurement of the related accrual, though we readily acknowledge a tradeoff (i.e., financial
reporting quality encompasses a broad array of accruals).
Healy and Wahlen (1999) suggest that a focus on specific accruals is a fruitful area for
future research, as it may allow for more direct and powerful tests. We examine ABD because

1
The Board notes that average tenure would be even longer if Andersen had not failed.
3

(1) it directly affects the valuation of accounts receivable, which is a fundamental component of
operating working capital; (2) it is subject to discretion and, thus, can be used to manage
earnings (e.g., McNichols and Wilson 1988; Teoh et al. 1998); (3) it is associated with revenues
(i.e., credit sales), which often are involved in fraudulent financial reporting (e.g., Beasley et al.
1999; Beasley et al. 2010);
2
and (4) professional standards (AS No. 12) require auditors to
consider revenues, specifically, in identifying and assessing the risks of material misstatement
(PCAOB 2010). We examine ABD to gauge its association with auditor tenure at any given
point in time.
We find evidence of a negative association between auditor tenure and estimated ABD.
The finding holds across a series of robustness tests. Further analyses suggest that long tenure is

associated with a downward bias in estimated ABD. The downward bias appears with auditor
tenure of around 15 years. With long tenure, the auditor endorses an estimate of ABD that is too
aggressive. This result is consistent with the argument that long tenure leads to compromised
independence. Our findings suggest that a term limit of 10 years, which has been suggested
elsewhere (e.g., PCAOB 2010; Chasan 2011), is sufficient to preserve auditor independence.
The remainder of the paper is organized as follows. Next, we provide a framework,
including our research hypothesis. Subsequently, we describe the research design and then
present the empirical findings. Lastly, we offer concluding remarks.

2. Framework
The auditor conducts an examination to collect evidence on a company’s financial data,
most notably its earnings. The audit examination provides insight into the distribution of

2
Brazel et al. (2010) examine financial fraud cases that involve revenues and find that accounts
receivable/allowance for bad debts are involved in 66 percent of the cases.
4

accounting earnings. The auditor learns a distribution, rather than an exact value, because
financial data depend on the application of accounting principles and significant estimates, both
of which require professional judgment. The auditor’s best assessment of earnings is the mean
of the earnings distribution.
The auditor opines on accounting earnings, which are announced and publicly disclosed.
The auditor may incur various costs if accounting earnings are misstated, including increased
legal exposure and client frictions. From the perspective of the auditing firm (the national office),
the costs of legal exposure may be paramount. The overall firm may prefer to report
conservatively in order to minimize the expected litigation cost, especially if the legal regime is
strict. As such, the auditing firm may prefer to endorse an accounting value that is biased
downward: that is, a value that falls below the mean of the earnings distribution.
The engagement partner, on the other hand, may be more focused on the costs of client

frictions, which arise when client relations are strained. The partner’s performance evaluation,
compensation, and professional status may be tied directly to his or her ability to cultivate and
maintain client relations. Thus, the partner may be incentivized to acquiesce to client demands
(e.g., Francis 2004; Knechel et al. 2011). The client, on average, may prefer to report
aggressively, with the aim being to create a more favorable financial picture (e.g., to secure
better credit terms or to bolster stock prices). The engagement partner, in turn, may feel
compelled to support the client’s position. Moore et al. (2006) suggest that an unconscious, self-
serving bias may make the partner susceptible to the client’s arguments and demands,
undermining objectivity. Likewise, the PCAOB has expressed concern that audit partners “may
have a bias toward accepting management's perspective, rather than developing an independent
view or challenging management's conclusions” (PCAOB 2011, 7). Accordingly, the
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engagement partner may be predisposed to endorse an accounting value that is biased upward:
that is, a value that exceeds the mean of the earnings distribution.
The engagement partner’s (audit team’s) bias may be magnified as auditor tenure
increases. In the early years of an engagement, bias may subtly creep into auditors’ judgment,
providing a ready means to foster client relations. Bazerman et al. (2002, 100) assert that the
auditor may unknowingly adapt to “small imperfections in a client’s financial practices.” Over
time, the auditor’s objectivity may deteriorate, ever so gradually, to the point that larger
imperfections are accepted, which may have significant implications for financial reporting
quality (e.g., Bazerman et al. 1997; Bazerman et al. 2002; Moore et al. 2006). In turn, the
potential negative consequences of rejecting the client’s position may increase as auditor tenure
increases, with any backlash realized immediately. In cases of long tenure, the auditor may
come to interpret evidence from a partisan perspective (Moore et al. 2006). Ongoing relations
may cause the auditor to more closely identify with the client, making it more likely that the
auditor will endorse the client’s position (e.g., Bamber and Iyer 2007). Simply put, long tenure
may undercut objectivity.
For our purposes, long tenure increases the possibility that the auditor approves of more
aggressive accounting estimates, effectively increasing earnings. We are interested in the

auditor’s assessment of ABD, as it gives ample room for discretion. Examples of companies’
that have understated ABD, under the auditor’s watchful eye, are plentiful including Friedman’s
Jewelers ( Satyam (Kahn 2009),
Advocat (Mulford and Comiskey 2002, 241), Miniscribe (Albrecht et al. 2009, 144), and
NextCard (Knapp 2010, 78), just to name a few. With long tenure, the auditor may come to
embrace the client’s perspective, wanting to believe that the assessment is correct. Hence, we
6

posit that as tenure increases, the auditor more readily accepts the client’s estimate of ABD,
which on average is too aggressive (too low). Formally stated, our research hypothesis is as
follows.
Hypothesis: Ceteris paribus, the allowance for bad debts (ABD) is a decreasing function
of auditor tenure.

3. Research Design
We examine clients’ ABD over time to test for an association with auditor tenure. As
discussed above, the audit firm (national office) prefers to report conservatively, whereas the
engagement partner (local office) prefers to report aggressively. Because the engagement
partner makes the reporting decision, the partner’s preferences may prevail. We conduct
empirical tests to examine this issue.
We consider the following regression model.
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௜௧
.
The dependent variable, ABD, is measured as the estimated bad debts scaled by total accounts
receivable. The primary independent variable of interest is auditor tenure (TENURE), measured
as the number of consecutive years that the auditor is engaged with the same client.
3
Other
independent variables are defined as follows:
AGE number of years the firm exists on the Compustat database;

3
The change of auditor due to audit firm mergers is treated as a continuation of the predecessor auditor.
7

∆SALE change of sales from year t-1 to year t scaled by the beginning total assets
((data12
t
– data12
t-1
)/data6
t-1
);

CFO cash flow from operations scaled by the beginning total assets
(data308
t
/data6
t-1
);

SIZE log transformation of the year-end market value of equity (ln(data25
t

*data199
t
));

ROA net income scaled by the beginning total assets (data172
t
/data6

t-1
);

ROA_SD standard deviation of ROA for the last three years;

LOSS an indicator variable that equals to 1 if data172
t
< 0 and 0 otherwise;

LEV total liabilities to total assets ratio (data181
t
/data6
t
);

CR ratio of current assets to current liabilities (data4
t
/data5
t
);

INDGROW growth in sales in an industry (
∑
݀ܽݐܽ12
௜௧௜
/
∑
݀ܽݐܽ12
௜௧ିଵ௜
);

FIRMGROW growth in sales of a firm (data12
t
/data12
t-1
);

BIG an indicator variable that equals 1 when the auditor is a Big 4 firm and 0
otherwise;

SPECIAL an indicator variable that equals 1 when the auditor audits the largest
portion of total assets in an industry and 0 otherwise; and

TENURE_SPECIAL an interactive variable that equals the product of TENURE and
SPECIAL.

Because accrual recognition varies across industries and time, we include two-digit SIC codes to
capture industry fixed effects and indicators for years to capture time fixed effects.
The control variables are similar to those in Myers et al. (2003) and Gul et al. (2009).
Firm age (AGE) is included to mitigate the possible confounding effects of firm maturity and to
control for differences associated with different firms’ life cycles (Anthony and Ramesh 1992).
Other variables associated with accruals also are included. We control for the change in
revenues (∆SALES), as it may directly impact ABD; cash flow (CFO) because prior studies show
8

an association between cash flow and accruals (e.g., Dechow 1994); and firm market value (SIZE,
SIZE
2
, and SIZE
3

) because larger firms have more stable accruals (Dechow and Dichev 2002)
and the size effect is non-linear (Gul et al. 2009). We also control for growth (INDGROW,
FIRMGROW) because firms in expanding or contracting industries may have different accrual
behavior (Gul et al. 2009); leverage (LEV, CR) as there are documented associations between
leverage and accruals (e.g., Butler et al. 2004); performance (LOSS, ROA, and ROA_SD) because
it is associated with accruals; and finally auditor size and specialization (BIG, SPECIAL, and
TENURE_SPECIAL) because auditors’ specialization is associated with accruals (e.g., Gul et al.
2009).

4. Data and Empirical Findings
4.1. Sample Composition and Descriptive Statistics
The initial sample consists of all firms for the years from 1988 to 2006 in the Compustat
database. We restrict our analyses to this time period because reported operating cash flows as
per SFAS No. 95 (FASB 1987) are only available since 1988. We exclude firms in the financial
services industries (SIC codes between 6000-6999). The firm’s age and the auditor tenure
variables are calculated from all available data in Compustat.
We delete firms with negative total assets, sales, debt, and market values of equity
because such observations introduce noise into the analyses. To mitigate problems caused by
extreme observations in cash flows and ABD, we exclude observations in the top and bottom 0.5
percentile. To avoid the confounding effects of start-up firms, we drop observations of all firms
in their first five years of existence. Firms that switch auditors in the first five years also are left
out because such firms may differ systematically from other firms (Myers et al. 2003).
9

Following Myers et al. (2003) and Gul et al. (2009), we eliminate firms that undergo merger and
acquisitions, as Hribar and Collins (2002) show that estimating accruals for such firms is
problematic. After imposing all the necessary requirements, we obtain a final sample of 15,226
firm-year observations.
Figure 1 illustrates the relationship between estimated bad debts scaled by total accounts
receivable (ABD) and auditor tenure. Panel A is a scatter illustration of the relationship. Two

features can be easily identified: the amount of ABD, as well as the range, is reduced as auditor
tenure increases. Panel B illustrates the relationship between auditor tenure and various statistics
of ABD. The mean of ABD is clearly a decreasing function of auditor tenure. The 90
th
percentile
of ABD has a very strong negative relationship with tenure, while the 10
th
percentile does not
show a systematic relationship.
Insert Figure 1 about here

Table 1 reports the descriptive statistics for estimated bad debts, auditor tenure, and the
control variables for the sample period. The average ABD is 6.1 percent, the average auditor
tenure is 10.34 years, and the average firm age is slightly over 27 years.
Insert Table 1 about here
Table 2 presents pairwise correlations among the independent variables. Notably, auditor
tenure and firm age are highly correlated (with a correlation efficient of 0.616, p < 001). We
further discuss this issue in our sensitivity analyses.
Insert Table 2 about here
10

4.2. The Effect of Long Tenure on Allowance for Bad Debts
Table 3 presents the results of the main regression model. The coefficient of TENURE is
negative and statistically significant at p < 0.01. The finding suggests that, on average, auditors
who have longer relationships with their clients endorse financial statements with lower
allowance for bad debts. This result is consistent with our research hypothesis.
Insert Table 3 about here
4.3. Orthogonal Regression
As noted earlier (refer to Table 2), auditor tenure and firm age are highly correlated and
the effect of each on ABD is similar. The high correlation is inherent because longer tenure is

conditioned on client existence (i.e., for auditor tenure to be long, the client must have a long
life). Notwithstanding, the high correlation creates a multicollinearity problem and, in turn, it is
not clear whether our findings are truly generated by auditor tenure or firm age. To mitigate this
concern, we rerun the regressions using an orthogonalized value of auditor tenure: that is,
orthogonal to firm age or to all control variables. As shown in Table 4, inferences are unaffected.
The coefficient of O_TENURE (orthogonal tenure) is negative and statistically significant at p <
0.01, which is consistent with our research hypothesis. We point out that using the orthogonal
value of auditor tenure may understate its effect on ABD because AGE and TENURE are
positively associated.
Insert Table 4 about here
4.4. The Effect of Long Tenure on Auditor Independence
We are interested in determining whether long tenure leads to impaired independence.
The negative association between auditor tenure and ABD, documented above, is consistent with
11

this explanation. The auditor may face pressure to preserve client relations, particularly as tenure
increases, which may prod the auditor to endorse an aggressive estimate of ABD (one that is
biased downward). Over time the social bond with the client may strengthen, making it more
likely that the auditor endorses an estimate of ABD that is too low. Hence, the reported ABD, on
average, decreases as auditor tenure increases.
An alternative explanation, however, also applies. In the initial years of an engagement,
the auditor may endorse a conservative estimate of ABD (one that is biased upward), with the
aim being to minimize expected litigation cost. In this case, the engagement partner adopts the
overall firm’s preference, with a focus on type II errors. As tenure increases, the auditor
becomes more familiar with the client’s business, operations, and accounting policies and, in turn,
is better able to manage engagement risk (e.g., Geiger and Raghunandan 2002; Carcello and
Nagy 2004). The improved knowledge allows the auditor to better gauge ABD. Accordingly,
over time the auditor may endorse an estimate of ABD that is less conservative, such that the
bias in the estimate is reduced, but still positive (i.e., still conservative).
For our purposes, the competing explanations arise because ABD is an estimate and its

true (correct) value is not known a priori. As such, it is difficult to determine whether the
auditor endorses an estimate of ABD that is aggressive or conservative. To gain further insight
into the negative association between auditor tenure and ABD, we identify a scenario in which
the client is predisposed to report aggressively.
Prior studies provide overwhelming evidence that companies making new equity
offerings have incentives to present a more favorable financial picture (Rangan1998; Teoh et al.
1998; Shivakumar 2000). The objective is to increase the proceeds of the offering. One means
to improve the financial picture is to make more aggressive estimates, including reducing ABD.
12

Consequently, we examine the impact of a new equity offering on the reported ABD in the year
immediately preceding the offering.
Ceteris paribus, a new equity offering in the subsequent year should not affect the
unbiased estimate of ABD in the current year. But the scenario introduces tension because the
auditor faces conflicting pressures. On the one hand, the client prefers a smaller ABD, and the
auditor may endorse a lower value to preserve client relations. On the other hand, the stock
offering increases the auditor’s exposure to potential liability, and the auditor only may endorse a
higher value to minimize expected litigation cost. We can determine whether the auditors with a
particular tenure compromise independence by measuring the impact of the new equity offering
on ABD for firms by auditors with the given tenure.
To measure the effect of new equity financing on ABD with given auditor tenure, we
need to add a variable FINANCE and an interactive variable TENURE_FINANCE to our
regression model. The variable FINANCE is the amount of new equity financing in year t+1
scaled by total assets at the end of year t (data108
t+1
/data6
t
). New financing increases the
auditor’s engagement risk, which suggests that the auditor may be conservative in assessing
ABD (and other accounting estimates). If so, the coefficient of FINANCE will be positive.

The interactive variable TENURE_FINANCE is simply the product of auditor tenure and
the amount of the new offering. The sign of the coefficient may be negative because TENURE
and FINANCE have opposite predicted effects on ABD. The rationale is straightforward. The
new equity offering increases the auditor’s engagement risk, introducing pressure to increase
ABD. But longer tenure has a counter effect, either creating pressure to compromise
independence or allowing the auditor to make a more precise estimate of ABD (and better
manage engagement risk). In either case, the effect is to decrease ABD. As elaborated below,
13

we examine the sum of the coefficient of FINANCE and the product of TENURE and the
coefficient of TENURE_FINANCE to disentangle the competing explanations.
The regression results are shown in Table 5. As before, the coefficient of TENURE is
negative and statistically significant at p < 0.01. The coefficient of FINANCE is positive and
statistically significant at p < 0.01. Further, the coefficient of TENURE_FINANCE is negative
and statistically significant at p < 0.01.
Insert Table 5 about here
Because our objective is to determine whether auditors’ concern over preserving client
relations leads to compromised independence, we need to isolate the total marginal impact of
new financing. For a given value of TENURE, the total marginal impact is the sum of the
coefficient of FINANCE and the product of TENURE and the coefficient of TENURE_FINANCE.
As we mentioned above, new financing in year t+1should not impact the unbiased estimate of
ABD in year t. If the total marginal effect is negative, it is indicative of impaired independence.
A total negative effect suggests that the auditor complies with client pressure to endorse an
estimate of ABD that biased downward (aggressive). On the other hand, if the total marginal
effect is positive, it suggests that the auditor maintain independence. In this case, the auditor’s
concern with potential liability prevails, and the auditor endorses an estimate of ABD that is
biased upward (conservative).
The results of the total marginal impact of new equity financing with various years of
auditor tenure are shown in Table 6. For each given value of auditor tenure (1-27), we compute
the total marginal impact and test whether it is significantly different from zero. For auditor

tenure of one to eight years, the sum is positive and statistically significant at p < 0.05. As tenure
lengthens, however, the total marginal impact becomes negative, reaching statistical significance
14

(p < 0.10) in the 18
th
consecutive engagement. Moreover, the statistical significance improves
over time (to 5 percent in the 19
th
year and 1 percent in the 26
th
year).
Insert Table 6 about here
The finding indicates that the impact of new financing on estimated ABD is positive in
the earlier years of the auditor-client relationship, but that it becomes negative when the tenure is
long. In other words, auditors with short tenure endorse an estimate of ABD that is conservative.
When tenure becomes long, however, auditors endorse an estimate of ABD that is aggressive,
which suggests that they compromise independence. In our sample, about 25 percent of auditors
have tenure longer than 16 years. Therefore, the majority of auditors in our sample maintain
independence.
4.5. Additional Analyses
We consider the possibility that our results in Table 6 may be biased because we have
assumed a linear relation between auditor tenure and the total marginal impact of new equity
financing on estimated ABD. Davis et al. (2009) suggest that tenure may have a nonlinear effect
on the auditor’s willingness to approve aggressive accounting estimates. If so, the estimated
coefficient for TENURE_FINANCE may not be the same for auditors with short and long tenure.
To test this possibility, we divide our sample into two subsamples based on the length of auditor
tenure: sample 1 includes companies with auditor tenure from 1-14 consecutive engagements and
sample 2 to includes companies with auditor tenure with at least 15 consecutive engagements.
We estimate the coefficients of FINANCE and TENURE_FINANCE for each sample (as

in Table 5). Then, using the sample-specific coefficients, we calculate the total marginal impact
of new financing on estimated ABD for a given auditor tenure. The results, presented in Table 7,
indicate that for sample 1 (auditor tenure of 1-14 years), the marginal effect is positive and
15

statistically significant (p < 0.05) for consecutive engagements of one to eight years. This
finding is consistent with the results in Table 6 and suggests that the auditor endorses a
conservative estimate of ABD in the earlier years of auditor-client relations. For sample 2
(auditor tenure of 15-27 years), the marginal effect is negative and statistically significant (p <
0.01) for consecutive engagements of 15 to 27 years (every year in the sample). This finding
also is similar to that in Table 6. Hence, the results continue to suggest that long tenure impairs
auditor independence.
Insert Table 7 about here
We rerun the regression model using the change in new financing as an independent
variable, rather than the level of new financing, because it is more directly related to the change
in client incentives (i.e., the need to present a more favorable financial picture): the bigger the
change in new financing, the stronger the client’s incentives. In this case, we have a variable
∆FINANCE and an interactive term TENURE_∆FINANCE added to the regression model, where
∆FINANCE is the difference in FINANCE between year t+1 and year t and
TENURE_∆FINANCE is the product of TENURE and ∆FINANCE. We document similar results
(not tabulated) as with the level of new financing variable (refer to Table 5). We also calculate
the marginal value of the change in financing on the estimate of ABD and test whether it is
significantly different from zero. The results (not tabulated) are comparable to those using the
level of new financing variable (refer to Table 6).

5. Concluding Remarks
We report the results of a study designed to examine the association between auditor
tenure and clients’ estimate of allowance for bad debts (ABD), as endorsed by the auditor. We
16

focus on ABD because it is a fundamental and important accounting estimate that directly affects
operating working capital and operating income. By examining a specific accrual, we are able to
conduct a direct and powerful test and, thus, avoid some of the empirical challenges that arise in
examining total accruals (discretionary or abnormal).
We want to gain insight into whether long tenure undermines auditor independence.
Regulators assert that long tenure incentivizes the auditor (engagement partner) to focus on
preserving client relations, perhaps to the detriment of audit quality. The primary concern is that
long tenure may cause the auditor to more readily acquiesce to client demands. For our purposes,
the auditor may approve an estimate of ABD that is too aggressive (too low).
We find evidence of a negative association between auditor tenure and estimated ABD.
Subsequent analyses suggest that long tenure is associated with a downward bias in estimated
ABD, which suggests that the auditor endorses a value that is too aggressive. The downward
bias arises when the auditor’s tenure is around 15 years. Our findings are consistent with the
conjecture that long tenure can lead to compromised independence.
The PCAOB (2011) is currently considering the merits of mandatory auditor rotation.
The Board has expressed a specific interest in a rotation period of ten years. Likewise, Arthur
Levitt, former Chairman of the SEC, has voiced a similar sentiment (Chasan 2011). Our findings
suggest that there are merits to limiting the number of years of an auditor-client relation.
Furthermore, our findings suggest that a term limit of ten years is sufficient to maintain auditor
independence.

17

Figure 1
The Graphic Relationship between Auditor Tenure and Allowance for Bad Debts

Panel A: Scattered graph between auditor tenure and ABD

Panel B: Graphic illustration of ABD statistics and auditor tenure

This figure shows the relationship between auditor tenure and the mean, median, 10
th
percentile
and 90
th
percentile of ABD


0 .5 1 1.5
ABD
0 10 20 30
TENURE
0
0.02
0.04
0.06
0.08
0.1
0.12
0.14
0.16
0.18
0.2
1 2 3 4 5 6 7 8 9 10111213141516171819202122232425262728293031323334
mean
p10
p50
p90
18

Notes: The sample consists of all firm-years from 1988 to 2006 from Compustat. We delete firms in the financial
services industries (SIC codes between 6000-6999). We delete firms with negative total assets, sales, and market
values of equity. We exclude in the top and bottom 0.5 percentile of cash flows and ABD. Finally, we exclude
observations of firms who did not continue with the same auditor for at least for five years and for firms in the first
five years of existence. The final sample consists of 15,226 firm-year observations.

19

Table 1
Descriptive Statistics
a

Sample Distribution of Variables
b
Variable Mean Std. Dev.
10
th
Pctile 25
th
Pctile
Median
75
th
Pctile 90
th
Pctile
ABD
0.061 0.092 0.010 0.019 0.036 0.066 0.124
TENURE
10.672

7.355
3.000
5.000
8.000
16.000
22.000
AGE
27.564
12.831
11.000
16.000
26.000
36.000
47.000
∆SALE
0.111
0.478
-0.169
-0.026
0.067
0.208
0.426
CFO
0.063
0.175
-0.083
0.016
0.081
0.144
0.213

SIZE
5.016
2.206
2.148
3.383
4.926
6.515
7.981
ROA
0.003
0.202
-0.166
-0.023
0.037
0.087
0.149
LEV
0.544
0.484
0.188
0.319
0.508
0.675
0.854
CURR
2.662
2.773
0.890
1.320
1.986

3.078
4.894
INDGROW
1.090
0.187
0.945
1.010
1.074
1.146
1.219
FIRMGROW
1.122
0.545
0.860
0.975
1.066
1.180
1.376
Categorical
variable
BIG
0.849
LOSS
0.300
SPECIAL
0.229
Observations
15,266

a

The sample consists of all firm-years from 1988 to 2006 from Compustat. We delete firms in the financial
services industries (SIC codes between 6000-6999). We delete firms with negative total assets, sales, and market
values of equity. We exclude 0.5% of the cash flow and ABD at each extreme. Finally, we exclude observations of
auditors that did not last at least for 5 years and first 5 years of a firm existence. The final sample consists of 15,266
firm-year observations.

20

Table 2
Pairwise Correlations among Variables
a
Variable
b
ABD
TENURE
AGE
∆
SALE
CFO
SIZE
ROA
LEV
CURR
INDGROW
FIRMGROW
BIG
LOSS
SPECIAL
ABD 1.000
TENURE -0.132 1.000

0.000
AGE -0.110 0.616 1.000
0.000 0.000
∆
SALE -0.023 -0.068 -0.085 1.000
0.004 0.000 0.000
CFO -0.104 0.130 0.133 0.035 1.000
0.000 0.000 0.000 0.000
SIZE -0.234 0.315 0.282 -0.003 0.259 1.000
0.000 0.000 0.000 0.722 0.000
ROA -0.150 0.118 0.130 0.181 0.764 0.224 1.000
0.000 0.000 0.000 0.000 0.000 0.000
LEV 0.079 0.017 0.060 -0.053 -0.088 0.062 -0.181 1.000
0.000 0.039 0.000 0.000 0.000 0.000 0.000
CURR -0.043 -0.067 -0.090 0.009 -0.061 -0.190 0.037 -0.309 1.000
0.000 0.000 0.000 0.297 0.000 0.000 0.000 0.000
INDGROW 0.032 -0.038 -0.036 0.040 0.019 -0.053 0.013 0.020 -0.024 1.000
0.000 0.000 0.000 0.000 0.021 0.000 0.119 0.012 0.003
FIRMGROW -0.025 -0.089 -0.098 0.373 -0.093 -0.030 -0.013 -0.047 0.042 0.031 1.000
0.002 0.000 0.000 0.000 0.000 0.000 0.119 0.000 0.000 0.000
BIG -0.047 0.153 0.050 0.005 0.095 0.389 0.070 0.005 -0.042 -0.011 -0.014 1.000
0.000 0.000 0.000 0.547 0.000 0.000 0.000 0.563 0.000 0.161 0.096
LOSS 0.145 -0.141 -0.155 -0.183 -0.442 -0.222 -0.616 0.159 -0.033 -0.014 -0.040 -0.059 1.000
0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.087 0.000 0.000
SPECIAL -0.013 0.095 0.036 -0.009 0.041 0.206 0.029 0.027 -0.021 0.003 -0.013 0.229 -0.016 1.000
0.097 0.000 0.000 0.289 0.000 0.000 0.000 0.001 0.010 0.673 0.111 0.000 0.054
a
The sample consists of all firm-years from 1988 to 2006 from Compustat. We delete firms in the financial services industries (SIC codes between 6000-6999).
We delete firms with negative total assets, sales, and market values of equity. We exclude 0.5% of the cash flow and ABD at each extreme. Finally, we exclude
observations of auditors that did not last at least for 5 years and first 5 years of a firm existence. The final sample consists of 15,266 firm-year observations.

21

Table 3
The Relationship between Auditor Tenure and Allowance for Bad Debts
a

Variables
b
Coef.
t-stat.
INTERCEPT
0.0865
***
4.95
TENURE
-0.0007
***
-3.75
AGE
-0.0001
-0.81
∆SALE
-0.0055
*
-1.80
CFO
0.0508
***
5.40
SIZE

-0.0206
***
-3.16
SIZE
2
0.0027
**
2.28
SIZE
3
-0.0001
*
-1.66
ROA
-0.0985
***
-7.79
ROA_SD
0.0067
1.38
LOSS
0.0083
***
2.66
LEV
0.0015
0.51
CR
0.0006
0.85

INDGROW
-0.0012
-0.36
FIRMGROW
-0.0024

-0.57
BIG
0.0057
1.31
SPEICAL
-0.0033
-0.81
TENURE_SPECIAL
0.0002
0.60
Year Fixed Effect
Industry Fixed Effect
No. of Observations
R
2
0.164
Yes
Yes
15,226
Independent Variable =
ABD
b

*, **, ***

Indicate significance at the 0.10, 0.05, and 0.01 levels, using two-tailed tests.
This table presents the results of relationship between auditor tenure and current allowance for
bad debts. The t-statistics are calculated using clustered standard errors by firm for the
multivariate analyses.
a
The sample consists of all firm-years from 1988 to 2006 from Compustat. We delete firms in the financial services
industries (SIC codes between 6000-6999). We delete firms with negative total assets, sales, and market values of
equity. We exclude 0.5% of the cash flow and ABD at each extreme. Finally, we exclude observations of auditors
that did not last at least for 5 years and first 5 years of a firm existence. The final sample consists of 15,266 firm-
year observations.

22

Table 4
The Relationship between Auditor Tenure and Allowance for Bad Debts Using Orthogonal
Audit Tenure to Firm Age
a
Variables
b
Coef.
t-stat.
INTERCEPT
0.0856
***
4.90
O_TENURE
-0.0046
***
-3.74
AGE

-0.0003
***
-3.77
∆SALE
-0.0055
*
-1.80
CFO
0.0508
***
5.40
SIZE
-0.0206
***
-3.16
SIZE
2
0.0027
**
2.28
SIZE
3
-0.0001
*
-1.66
ROA
-0.0985
***
-7.79
ROA_SD

0.0067 1.38
LOSS
0.0083
***
2.66
LEV
0.0015 0.51
CR
0.0006 0.85
INDGROW
-0.0012 -0.36
FIRMGROW
-0.0024

-0.57
BIG
0.0057 1.31
SPEICAL
-0.0033 -0.81
TENURE_SPECIAL
0.0023 1.08
Year Fixed Effect
Industry Fixed Effect
No. of Observations
R
2
Dependent Variable=
ABD
0.164
Yes

Yes
15,226

This table presents the results of relationship between auditor tenure and current allowance for
bad debts using orthogonal auditor tenure to firm age. Specifically, the orthogonal audit value is
the residual of the regression of audit tenure on firm age. The t-statistics are calculated using
clustered standard errors by firm for the multivariate analyses.
a
The sample consists of all firm-years from 1988 to 2006 from Compustat. We delete firms in the financial services
industries (SIC codes between 6000-6999). We delete firms with negative total assets, sales, and market values of
23

equity. We exclude 0.5% of the cash flow and ABD at each extreme. Finally, we exclude observations of auditors
that did not last at least for 5 years and first 5 years of a firm existence. The final sample consists of 15,266 firm-
year observations.