Auditor Tenure and Earnings Quality: Effect of Client-Specific Knowledge

Bin Srinidhi
The Hong Kong Polytechnic University
Hong Kong

Sidney Leung
City University of Hong Kong
Hong Kong

Ferdinand Gul
The Hong Kong Polytechnic University
Hong Kong

Abstract:
In this paper, we argue that audit tenure increases client-specific knowledge which makes the earnings quality benefits of longer audit tenure more significant in client firms whose audits demand more client-specific knowledge. We identify that firms whose market and operating characteristics differ materially from industry norm and firms with high volatility in operating performance as firms that demand more client-specific knowledge. We provide evidence of greater earnings quality improvements from long auditor tenure in these firms. Next, we show that client-firm size is a good inverse proxy for the demand on client-specific knowledge because small firms have higher volatility in cash flows, sales and earnings, higher levels of market beta, and higher debt, inventory and accounts receivable ratios than large firms. Using size as a proxy for the demand for client-specific knowledge, we show that the association between longer tenure and higher accrual quality is stronger for small firms than for large firms. Our findings are robust to alternative specifications of earnings quality.