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Auditor Tenure and Perceptions of Audit Quality
Author(s): Aloke Ghosh and Doocheol Moon
Source: The Accounting Review, Vol. 80, No. 2 (Apr., 2005), pp. 585-612
Published by: American Accounting Association
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THE ACCOUNTING REVIEW
Vol. 80, No. 2
2005
pp. 585-612
Auditor Tenure and Perceptions

of Audit Quality
Aloke Ghosh
U.S. Securities and Exchange Commission
and
Baruch College-The City Universityof New York
Doocheol Moon
State Universityof New Yorkat Old Westbury
ABSTRACT:We analyze how investors and informationintermediariesperceiveauditor
tenure. Using earnings response coefficients from returns-earningsregressions as a
proxyfor investorperceptions of earnings quality,we document a positive association
between investor perceptions of earnings qualityand tenure. Further,we find that the
influenceof reportedearnings on stock rankingsbecomes largerwithextended tenure,
although the association between debt ratings and reportedearnings does not vary
with tenure. Finally,we find that the influence of past earnings on one-year-ahead
earnings forecasts becomes greater as tenure increases. In general, our results are
consistent with the hypothesis that investors and informationintermediariesperceive
auditortenure as improvingaudit quality.One implicationof our study is that imposing
mandatorylimitson the durationof the auditor-clientrelationshipmight impose unin-
tended costs on capital marketparticipants.
Keywords: auditortenure;auditorindependence; audit quality;earningsquality;man-
datoryauditorrotation;capitalmarketperceptions.
Data Availability:All data used in this study are availablefrompublic sources.
We thankAshiq Ali, MarkBeasley, MartiBenis, Donal Byard,MasakoDarrough,PaquitaDavis-Friday,Anita

Dennis,Zeng Deng, RajibDoogar,Amy Edwards,MaryGreenawalt,ZhaoyangGu, LarryHarris,PremJain,Joe
Kerstein,Ying Li, SteveLilien,Steve Lustgarten,DariusMiller,two anonymousreferees,SriniSankaraguruswamy,
BharatSarath,Dave Smith,JonathanSokobin,Jan Sweeney,TonyTinker,Joe Weintrop,and JimmyYe for their
helpfulcomments.This paperwas previouslytitled:"Does AuditorTenureImpairAuditQuality?"Weacknowledge
financialsupportfrom the RobertZicklinCenterfor CorporateIntegrityof BaruchCollege.
The Securitiesand ExchangeCommissiondisclaimsresponsibilityfor any privatepublicationor statementby any
SEC employeeor commissioner.This paperexpressesthe authors'views and does not necessarilyreflectthose of
the Commission,the commissioners,or othermembersof the staff.
Editor'snote:This paperwas acceptedby TerryShevlin,SeniorEditor.
Submitted August 2002
Accepted August 2004
585
586 Ghosh and Moon
I. INTRODUCTION
he recentrise in accountingirregularities
has reopenedquestionsaboutauditorten-
ure, independence,and auditquality(Bricker2002).' Recentstudiesprovidevaluable
insights into the debate surroundingauditor tenure by examining the association
between tenureand (1) accountingaccruals,(2) analysts'forecasterrors,and (3) the cost
of debt. Myers et al. (2003) conclude that longer auditortenure constrains managerial
discretionwith accountingaccruals,which suggests high auditquality.Johnsonet al. (2002)
also find that accruals are larger and less persistentfor firms with short auditortenure
relative to those with medium or long tenure. Using credit spreadsbetween bond yields
and matchedTreasuryyields as the cost of debt, Mansi et al. (2004) find that the cost of
debt declines with longer tenure, which suggests bondholdersperceive audit quality as
improvingwith extendedtenure.In contrast,Davis et al. (2002) concludethatauditquality
declines with extended tenure because, as tenure increases, client firms have greaterre-
portingflexibilityand earningsforecasterrorsdecline.
This study focuses on how investorsand informationintermediariesperceive auditor
tenure. Using earningsresponse coefficients from returns-earningsregressionsas a proxy
for investorperceptionsof earningsquality,we analyzewhetherinvestorsperceiveearnings
quality as being affected by tenure. Given the importanceof informationintermediaries
who receive and process financialinformationfor investors,we also analyze whetherin-
dependentratingagencies and financialanalystsincorporatethe potentialeffects of tenure
on earnings quality. Specifically, we examine whether tenure affects the relationshipbe-
tween reportedearningsand (1) stock rankings,(2) debt ratings,and (3) analysts'earnings
forecasts.
A key distinctionbetween our study and those of Davis et al. (2002) and Mansi et al.
(2004) is the difference in the researchdesign. We examine whetherthe extent to which
analystsrely on past reportedearningsto predictfutureearningsvarieswith tenure,whereas
Davis et al. (2002) explore the associationbetween forecasterrorsand tenure.Ourresearch
design might be bettersuited because it is difficultto draw unambiguousinferencesabout
analysts'perceptionsfroman associationbetweenforecasterrorsandtenure.Lowerforecast
errorswith longertenuremight suggest thatearningsqualityis perceivedas improvingwith
tenurebecauseearningsare morepredictable.However,it could also suggest lower earnings
quality if managersincreasinglyguide earningsforecastsas auditortenurelengthens.Fur-
ther, Mansi et al. (2004) investigatethe influence of tenure on the cost of debt, whereas
we examine whetherthe influenceof reportedearningson debt ratingsvaries with tenure.
Although Mansi et al. (2004) examine the effect of tenure on debt ratings,their primary
aim is to purge(orthogonalize)the informationeffects of tenureand othercontrolvariables
relatedto debt ratingsand ultimatelyexamine the insurancerole of tenureon the cost of
debt. In contrast,our emphasis is on the informationalrole of tenure. Our fundamental
objective is to provide insights into any changes in the perceived credibilityof reported
earningswith extendedauditortenure.
Emphasison capitalmarketperceptionsof independenceand auditqualityis consistent
with the Financial Accounting Standards Board's (FASB) conceptual framework for finan-
cial reporting and principles of auditor independence (Carmichael 1999). According to the
Regulatorsexpressconcernsthatpressureto retainclient firmsandthe "comfortlevel"createdbetweenauditors

and managementover time impairauditorindependence,whichadverselyaffectsauditquality(U.S. Government
AccountingOffice [GAO]2003). The accountingprofession,on the other hand,claims that the likelihoodof
auditfailuresis greaterduringthe initialperiodof an auditor-clientrelationshipbecauseof lack of information
aboutclient-specificrisks (PricewaterhouseCoopers 2002).
TheAccountingReview,April 2005
AuditorTenureand Perceptionsof AuditQuality 587
Statementof FinancialAccountingConcepts (SFAC No. 1, FASB 1978), "financialstate-

ments are often auditedby independentaccountantsfor the purposeof enhancingconfidence
in their reliability."The AICPA (1994) also acknowledgesthe importanceof considering
investorperceptionsof auditorindependence.A formerchairmanof AICPA,Elliott (2000)
says "[The AICPA] believe[s] that appearancesare very importantand capital markets
requireconfidence in financialstatementsand audit reports,and the memberfirms of the
AICPAare basing theirbusinessof auditingon theirreputations,and thatis heavily affected
by appearance."
Other things remainingconstant, audited financial statementsare less reliable (or of
lower perceivedquality)for investmentand creditdecisions if users of financialstatements
view lengthytenureas having an adverseeffect on auditorindependenceand auditquality.
Alternatively,investorsand informationintermediariesare more likely to rely on reported
accountingnumbersif they perceive that greaterauditorexpertisefrom longer tenureim-
proves independenceand auditquality.We assertthat the relationshipbetween perceptions
of earningsqualityand auditortenureprovidesinsightsinto how capitalmarketparticipants
view auditortenureas affecting auditquality.
We use earningsresponsecoefficients (ERCs) from contemporaneousreturns-earnings
regressionsto measure investor perceptionsof earnings quality. After controllingfor the
other determinantsof ERC-such as the age of the firm, the quality of auditors,growth,
earningspersistence,earnings volatility, systematicrisk, firm size, financialleverage, and
regulatoryenvironment-we find that the magnitudeof the ERC increasesas the auditor-
client relationshiplengthens. One concern is that if the market anticipatesa portion of
currentearningsmore thanone-year-aheadof the earningsrelease, then the estimatedERC
might be biased downward(Kothari 1992; Kothariand Sloan 1992). Additionally,if the
marketis more likely to anticipatecurrentearningsfor firms with longer tenure,then the
bias might be associatedwith tenure.Consistentwith the premisethatprices lead earnings,
the estimatedERC for firms with extended tenureis largerwhen we increase the returns
measurementwindow or when we use non-marketmetrics, such as total assets, to deflate
earnings.Thus, the ERC-basedfindings are consistent with the hypothesis that investors
perceive auditortenureas enhancingearningsquality.
Further,controllingfor the otherdeterminantsof stock rankings,we find thatthe influ-
ence of reportedearningson Standard& Poor's (S&P) common stock rankingsbecomes
larger with extended tenure. In contrast, the association between S&P debt ratings and
reportedearningsdoes not vary with tenure.Thus, our resultsprovidemodestevidence that
independentratingagencies perceivereportedearningsas being morereliablefor firmswith
longer tenure.
Finally,aftercontrollingfor factorsthat affect analysts'earningsforecasts,we find that
the influence of past earnings on one-year-aheadearnings forecasts becomes largerover
extended auditor-clientrelationships.All else equal, analysts are more likely to rely on
reportedearnings to predict future earnings with longer tenure. Thus, the results from
analystearningsforecastsalso suggest that analystsperceiveearningsqualityas improving
with longer auditor tenure.
While our results are based on a large sample of firms spanning 11 years, there is one
concern with our dataset. If auditor tenure is endogenous to audit quality, then the results
are also consistent with an alternative hypothesis that auditor turnover is high for firms
with low earnings quality. In other words, high-quality auditors might terminate engage-
ments with client firms that prefer low-quality financial statements (DeFond and
Subramanyam 1998). We address potential concerns about frequent auditor turnover by
constructing a subsample for which the auditor-client relationship lasts for at least five
588 Ghoshand Moon
years, as in Myers et al. (2003). When we use this subsample, our inferences remain
unchangedfor all our tests.
In sum, our results are generallyconsistentwith the hypothesisthat reportedearnings
are perceived as being more reliable as auditortenure increases. One implicationof our
results is that capital marketparticipantsview longer auditortenureas having a favorable
impacton auditquality.Our resultssuggest thatimposingmandatorylimits on the duration
of the auditor-clientrelationshipmight impose unintendedcosts on capital markets.How-
ever, resultsfrom a regime withoutauditortermlimits may not be applicableto a regulated
environmentbecause of differencesin economic incentivesfor both auditorsand clients.
The rest of the paperis organizedas follows. Section II establishesthe links between
tenure, independence,and perceptionsof audit quality. Section III discusses the research
design, and Section IV describes the sample selection procedure.Section V reportsthe
results of the association between tenure and perceptionsof earningsquality. Section VI
concludes the paper.
II. TENURE, INDEPENDENCE, AND PERCEPTIONS OF AUDIT QUALITY

Independentauditorsare consideredthe "gatekeepers"of the public securitiesmarkets
(SEC 2001, III.A). However,the recent rash of accountingirregularitieshas led many to
question auditorindependence(WallStreetJournal 2002a, 2002b). One perceptionis that
auditorsare more likely to agree with managerson importantreportingdecisions as the
length of the auditengagementincreases(Ryan et al. 2001; Farmeret al. 1987). Therefore,
imposing mandatorylimits on auditortenure is expected to improve audit quality by re-
ducing client firms' influenceover auditors(Turner2002; Brody and Moscove 1998; SEC
1994; AICPA 1978; U.S. Senate 1977; Mautz and Sharaf 1961).
An opposing viewpoint is that problemaudits occur more frequentlyfor newer clients
because auditorshave less informationabout these firms (AICPA 1992). Client-specific
knowledge of items such as operations,accountingsystem, and internalcontrol structure
is crucial for auditorsto detect materialerrorsand misstatements.In particular,Johnsonet
al. (2002) argue that lack of adequateclient-specificknowledge duringthe early years of
engagementdecreasesthe likelihoodof detectingmaterialerrorsand misstatements.As the
auditor-clientrelationshiplengthens,firm-specificexpertiseallows auditorsto rely less on
managerialestimatesand become more independentof management(Solomon et al. 1999).
The crux of the debate rests on how tenureaffects auditorindependence.Proponents
of mandatoryauditorrotationclaim thatlengthyauditortenureerodes independence,which
in turn impairs audit quality. Others argue that independenceand audit quality increase
with longer tenure because of improved auditor expertise from superior client-specific
knowledge.2Since independenceis not observable,regulators,practitioners,and academics
often rely on the appearancedimensionto define auditorindependence(Dopuchet al. 2003;
Kinney 1999).
Our study investigateswhether capital marketparticipantsperceive longer tenure as
affecting audit quality.Insightsfrom a market-basedapproachare importantalong at least
two dimensions. First, academics often emphasize the need to understandcapital market
perceptionsof auditorindependenceand audit quality because ultimatelythe value of au-
diting services depends on perceptionsof independence(Dopuch et al. 2003; Shockley
2 Expertknowledgegainedthroughyearsof on-the-jobexperienceincreasesthe likelihoodthatauditorswill detect
errorsin financialstatements(Ashton 1991; Libby and Frederick1990). In contrast,industryspecialization,
anotherfrequentlyused proxy for auditorexpertise,is based on trainingand practicalexperiencegained from
auditingin a particularindustry(GramlingandStone2001; Solomonet al. 1999;HoganandJeter1999;Craswell
et al. 1995).
The AccountingReview,April 2005
Auditor Tenure and Perceptions of Audit Quality 589
1981). Second, regulatoryinstitutionssuch as the FASB (SFAC No. 1) and SEC (2000)
emphasize the importanceof capital marketperceptionsof auditorindependence.A per-
ception that the auditors'work is more objective and independentinspires greaterconfi-
dence in auditoropinion, which increases the perceived reliabilityor quality of reported
accountingnumbers(Ryan et al. 2001; Elliott and Jacobson 1998). Independentauditors
increasethe reliabilityof financialstatementsbecause (1) they are more likely to prevent
or detect and correctmaterialmisstatements/omissions,and (2) they ensure that financial
statementscomply with generallyacceptedaccountingprinciples(Carmichael1999).There-
fore, to the extent that capital marketparticipantsview tenureas improvingindependence
and auditquality,financialstatementsare perceivedas more reliablefor financialdecisions
as tenurelengthens.
In this study, we focus on the perceptionsof investorsbecause they are the principal
users of financialstatements.In its ConceptualFramework,the FASB defines "quality"in
relationto the usefulnessof financialstatementsto investorsand links "usefulness"in turn
to constructssuch as relevanceand reliability(SFACsNo. 1 [FASB 1978] and No. 2 [FASB
1980]). To drawinferencesaboutinvestors'perceptionsof earningsquality,researcherstend
to use stock-market-basedmetrics such as earningsresponse coefficients from regressions
of returnson earnings (Schipper and Vincent 2003; Warfieldet al. 1995). Prior studies
documentthat investorspay a largerpremiumfor "high-quality"earningsbecause high-
quality earnings are viewed as sustainable(Schipperand Vincent 2003; Teoh and Wong
1993). Thus, examiningthe influenceof auditortenureon the pricing of earningsis likely
to provide valuableinsights into investors'views of the associationbetween the length of
the auditor-clientrelationshipand earningsquality.
Given that informationintermediariesconstitutean integralpart of the capital market
by providing stock recommendations,debt ratings, and earnings forecasts (Lang and
Lundholm1996), we also analyze how independentratingagencies and financialanalysts
view auditortenure.Hunt(2002) statesthatindependentratingagenciesprovideinformation
about the creditworthinessof issuers and that credit ratings play a significantrole in in-
vestment decisions. Extant researchfinds links between earnings and debt ratings/stock
rankingsissued by independentrating agencies (Bhojrajand Sengupta2003; Ziebartand
Reiter 1992; Van Horne 1992; Kaplanand Urwitz 1979), suggesting that perceptionsof
earnings quality could be an importantinput in determiningrankings/ratings.Similarly,
financialanalystsalso play a prominentrole as informationintermediariesin capitalmarkets
because of their ability to incorporatevalue-relevantinformationin theirpublishedreports,
which impactssecurityprices (Francisand Soffer 1997; Schipper1991;Lys and Sohn 1990;
Brown et al. 1987). Priorresearchfinds that analystsrely on earningsreleases to estimate
future earnings (Kasznik and McNichols 2002; Barronet al. 2002; Stickel 1989), which
suggests that the extent to which analysts depend on reportedearningsto make earnings
forecastsmight vary with perceptionsof earningsquality.
Extendingthis line of research,we examinethe associationbetween auditortenureand
(1) stock rankings,(2) debt ratings,and (3) analysts'forecastsof earningsper share. Ad-
ditionally,we analyze how auditortenureaffects the associationbetween reportedearnings
and rankings,ratings, and earnings forecasts. If auditortenure is perceived as enhancing
earningsquality,then, all else equal, the influenceof reportedearningson rankings/ratings
and earnings forecasts is expected to become larger with longer auditortenure because
reportedearningsare viewed as more informativeabout futureearnings.The converse is
trueif informationintermediariesperceivelongerauditortenureas erodingearningsquality.
Based on the associationbetweenour proxy measuresfor perceptionsof earningsqual-
ity and auditortenure,we infer how investorsand informationintermediariesview auditor
The Accounting Review, April 2005
590 Ghoshand Moon
tenureas affectingauditquality.A positive relationshipbetweenthe proxiesfor perceptions

of earningsquality and auditortenure is consistent with the hypothesisthat longer tenure
is perceivedas improvingindependenceand audit quality.In contrast,a negative relation-
ship is consistentwith the hypothesisthatlengthytenureis viewed as erodingindependence
and audit quality.
III. RESEARCH DESIGN

We use the following basic regressionframeworkto analyze whetherinvestors,inde-
pendentratingagencies, and financialanalystsperceive earningsquality as being affected
by auditortenure:
Dependent variable = ac + PE + P2AE + 13E*Tenure + r4AE*Tenure

9
+ 35Tenure+ P36+2(j-1)E*Control variable.
j=1
9
+ )
AE*Control variable.
137+2(j-
j=1
9
+ E + E. (1)
j=1
323+jControlvariablej
E and AE are reportedearningsand changes in reportedearnings,respectively.Tenureis

the durationof the auditor-clientrelationship(calculatedusing Compustat#149) in years,
startingfrom 1982 (auditfirmmergersare consideredas a continuationof the priorauditor).
Subscriptj representsthe numberof controlvariables(1 to 9). Eachof the controlvariables
is interactedwith E/AE and is also includedas a separateindependentvariable.Details on
the dependentand control variablesare providedin subsequentsubsections.
The sum of earningslevels and changescoefficients(p, + 132)or the "earningsresponse
coefficient" (ERC) is our proxy for capital markets'perceptionsof earningsquality.Our
interestis in the sum of the E*Tenureand AE*Tenurecoefficients (P3 + 14). If investors,
ratingagencies, and analystsperceiveearningsqualityas improving(declining)with longer
auditortenure,133+ 34 is expected to differ from zero.
Perceptions of Investors and Auditor Tenure

We measure investor perceptionsof earnings quality using 12-month (ending three
monthsafterthe fiscal year-end)cumulativemarket-adjusted returns(CAR)as the dependent
variablein Equation(1). Market-adjustedreturnsare the difference between raw returns
and value-weightedCRSP marketreturns.
We include earningschanges and earnings levels in the same regressionbecause in-
cluding both increasesthe explanatorypower and magnitudeof earningsresponse coeffi-
cients when earningscontainboth transitoryand permanentcomponents(Eastonand Harris
1991; Ali and Zarowin1992). E is income before extraordinaryitems (Compustat#18) and
AE is the difference between income before extraordinaryitems for the currentyear and
that of last year. Both E and AE are deflatedby marketvalue of equity (Compustat#25
x #199) at the beginningof the year.
We include various control variablesbecause the ERC is associated with other firm
characteristics(Warfieldet al. 1995; Dhaliwal and Reynolds 1994; Collins and Kothari
1989), which, in turn, might be associated with tenure.The control variablesare defined
as follows: FirmAge,computed using the beginning and end dates as reportedin CRSP,
measuresthe numberof years that the firm has been publicly tradedas of the fiscal year-
end; Big4 is an indicatorvariablethatequals 1 when the client's auditoris a largeaccount-
ing firm (Compustat#149); Growthis the sum of the marketvalue of equity (Compustat
#25 x #199) and the book value of debt (Compustat#9 + #34) scaled by the book value
of total assets (Compustat#6); Persistence(Volatility)is the first-orderautocorrelation(stan-
dard deviation)of income before extraordinaryitems per share (CompustatQuarterly#8/
Quarterly#61) for the past 16 quarters;3Beta is systematicrisk computedusing the past
60 monthly stock returns;Size is the logarithmictransformationof the fiscal year-end
marketvalue of equity (Compustat#25 x #199) of the prioryear;Leverageis the ratioof
total debt (Compustat#9 + #34) to total assets (Compustat#6); and Regulation is an
indicatorvariablethat equals 1 for firms in a regulatedindustrywith two-digit standard
industryclassificationcodes between 40 and 49 or between 60 and 63.
We include FirmAgefor two reasons:(1) older firms are more likely to be stable with
less informationasymmetryproblems,which suggests higher ERCs; and (2) Tenureand
FirmAgeare positively correlated.We controlfor Big4 because large auditorsare generally
associatedwith high-qualityaudits (Becker et al. 1998; Teoh and Wong 1993). The inclu-
sion of Growth, Persistence, Volatility, and Beta is primarily motivated by valuation con-
siderations(Warfieldet al. 1995). The inclusion of Size is motivatedby the political cost
theory:managersof large, politically sensitive firms are more likely to exploit the latitude
in accountingto reducepolitical costs, which affects earningsquality.We includeLeverage
because of contractingconsiderations:firms with high leverage are more likely to use the
latitudein accountingto avoid possible debt-covenantviolations (DeFond and Jiambalvo
1994). Finally, the quality of earningsis affected in a regulatedenvironment(Regulation)
because managershave limited scope for opportunisticbehavior(Warfieldet al. 1995).
Perceptions of Information Intermediaries and Auditor Tenure

IndependentRating Agencies
Ouranalysisof how tenureaffects independentratingagencies' perceptionsof earnings
quality is based on estimates from Equation(1) using Standard& Poor's (S&P) common
stock rankings(StockRankings)and senior debt ratings(Debt Ratings) as dependentvari-
ables. StockRankingsrepresentnumericalvalues of 1 to 7, correspondingto S&P common
stock rankings(Compustat#282). A value of 1 is assignedif a firm'scommonstock ranking
is ratedas A+ and as S&P common stock rankingsdecline, the numericalvalue increases
by 1.4Similarly,Debt Ratings are assigned a value of I if a firm'sS&P senior debt (Com-
pustat#280) is ratedas AAA. As S&P debt ratingsdecline from AAA (the highest) to D
(paymentdefault),the numericalvalue increasesby 1.
We include Growth, Volatility, Beta, Size, and Leverage to control for cross-sectional
differences in firm quality and riskiness (Bhojrajand Sengupta 2003; Van Home 1992;
Ziebart and Reiter 1992; Kaplan and Urwitz 1979). Growing firms with high earnings
volatility tend to be more risky, Beta controls for both operatingand financialrisk, large
firms tend to be less risky, and firms with higher leverage have greaterfinancialrisk. We
also include FirmAge, Big4, Persistence, and Regulation because the association between
reported earnings and rankings/ratings might depend on the firm's life-cycle, whether firms
SSince Persistenceand Volatilitymeasuresare computedusing time-seriesincomeper sharenumbers,we adjust

for stock-splitsand stock dividendsthat occur subsequentto the end of a given periodusing the adjustment
factorreportedin Compustat(Quarterly#17).
4 For instance,values 2 through7 correspond to the S&P commonstock rankingsof A, A-, B+, B, B-, and C,
respectively.We do not includeS&P commonstock rankingsof D (in reorganization) and LIQ(liquidation)for
our samplebecauseof going-concernissues.
592 Ghoshand Moon
use big audit firms, whetherearningsare persistent,and whetherfirms are in a regulated

environment.
In a recent study, Mansi et al. (2004) find that longer tenurelowers the rate of return
requiredby bondholdersand thatthe impactis largerfor "information-sensitive" securities
such as non-investmentgrade bonds (debt ratings less than BBB-). Therefore,we also
separately estimate the effects of tenure on investment and non-investmentgrade debt
ratings.
Financial Analysts
Finally, our analysis of whether tenure influences financial analysts' perceptionsof
earnings quality is based on the estimates from Equation (1) using earnings forecasts
(FEPS,) as the dependent variable. FEPS, is the consensus analyst forecasts of annual
earningsper share from the InstitutionalBrokersEstimationSystem (I/B/E/S) database.
Our proxy for consensus forecasts is the mean one-year-aheadforecast for year t issued
immediatelyfollowing the earnings announcementfor year t- 1 (earningsannouncement
dates are obtainedfrom Compustat).5We restrictthe forecaststo those issued immediately
following earningsannouncements,as in Kasznikand McNichols (2002) and Barronet al.
(2002), because (1) any change in analysts'perceptionsof earningsquality is more likely
to be updatedfollowing earningsreleases (Barronet al. 2002), (2) it excludes stale forecasts
since forecast revisions are more common following earnings announcements(Stickel
1989), and (3) it conditionsthe forecastson the same set of publiclydisclosed information.
Reportedearningsper share (EPS,_, and AEPS,_,)are used as measuresfor E and AE
in Equation(1). EPS,_, is annualearningsper sharereportedfor year t- 1, and AEPS,_,is
the absolutechange in earningsper share for year t- 1 defined as the differencein annual
earnings per share in year t- I and that in year t-2 - EPS,_-2), both obtained
from the I/B/E/S database.As in Barronet al. (2002), (IEPS,_,
we include the absolute value of
changes in earningsbecausea largerearningssurprisetends to be temporary,which reduces
the potentialusefulnessof past earningsin predictingfutureearnings.
Since prior studies find that analysts' incentives to acquire informationabout future
earningsare affected by firm characteristics(DeFond and Hung 2003; Barronet al. 2002;
Lang and Lundholm1996), we include the following control variables:FirmAgebecause
older firmsare morelikely to be stableandconsequentlyearningsmightbe easierto predict;
auditortype (Big4) because analystsmight perceiveearningsqualityas improvingfor firms
with big auditors;Growthbecause high-growthfirms tend to generategreaterdemandfor
privateinformation,therebyreducingthe relianceon reportedearnings(Barronet al. 2002;
Lang and Lundholm 1996); Volatilitybecause analysts are more likely to attach lower
importanceon reportedearningsfor firmswith higherearningsvolatility(DeFondand Hung
2003); risk using a market-basedmeasure(Beta) and a balance-sheet-basedmeasure(Lev-
erage); Size because prior studies find that firm size is associatedwith risk and the infor-
mationenvironment,which affects earningspredictability(DeFondand Hung 2003; Barron
et al. 2002); Regulationbecausethe predictabilityof earningsmightvarybetweenindustries
(O'Brien 1990); and the numberof analysts(Analysts)providingannualearningsper share
SWe preferconsensusforecaststo individualforecastsbecausepriorresearchfinds that consensusforecastsare

moreaccuratethanthe individualforecastsunderlyingthe consensus.One explanationfor this resultis thatthe
forecasterrorsmade by individualanalystsare less than perfectlycorrelatedand thereforein the process of
aggregation,the individualforecasterrorsoffset each other (see Brownet al. 11985]for relatedpapers).The
resultsare similarwhen we use eitherthe meanor the medianforecast.
forecastsfor a firm (Lang and Lundholm1996). All the control variablesincludingTenure

are measuredat the end of year t- 1.
In a recent study, Davis et al. (2002) find that forecast errors decline as tenure in-
creases.6 However, it is difficult to draw unambiguousinferences about perceptionsof
analystsfrom an associationbetweenforecasterrorsand tenure.Lowerforecasterrorsmight
suggest that analysts perceive earningsquality as improvingwith tenurebecause earnings
are more predictable.Alternatively,lower forecasterrorswith longer tenuremight suggest
lower earningsquality if managersare more likely to guide earningsforecasts as auditor
tenure lengthens.7Hence, we do not focus on earningsforecastattributessuch as forecast
errorsand dispersion.
IV. DATA
We constructa sample from the list of publicly tradedfirms in the 2001 Compustat
annual files (active and research).Since the 2001 Compustatfiles cover 20 years of data,
and financialdata are availablefrom 1982, auditortenureis 1 for the firstyearby construc-
tion. The analysis begins with 1990 to provide some variationfor auditortenure and ex-
cludes the year 2001 because of possible missing and incompletedata.8Stock returnand
firm age data are obtainedfrom the 2001 CRSP files. We get earningsforecastdata from
the 2001 InstitutionalBrokersEstimationSystem (I/B/E/S) SummaryEstimates.
We impose the following restrictionson the sample:(1) we delete the top and bottom
1 percentof observationsfor the level of earnings(E), changes in earnings (AE), annual
earnings per share (EPS), and the absolute change in annualearningsper share (AEPS);
(2) we remove all observationswith the absolute value of cumulativemarket-adjusted re-
turns (CAR) greaterthan 100 percent;and (3) we also winsorize the top and bottom 1
percent of observations for Growth, Persistence, Volatility, Beta, and Leverage.9 This sample
selection procedureresults in a maximumof 38,794 observationsfor the "full" sample
over the years 1990 through2000.
Some concerns remain with the full sample. Firms might frequentlyswitch auditors
either because of "opinion shopping"(SEC 1988) or because of auditors'preferencefor
conservativeaccounting choices (DeFond and Subramanyam1998). Alternatively,high-
quality auditorsmight end engagementswith clients that prefer low quality of financial
6 Researchersfrequentlyuse forecasterrorsand dispersionamongforecastsas proxiesfor the uncertaintyamong

analystsaboutthe qualityof accountinginformation(Hope 2003; Duruand Reeb 2002; Ashbaughand Pincus
2001; Barronet al. 1998;Langand Lundholm1996).
7 Managershave strongincentivesto avoid negativeearningssurprisesbecauseof the largestock-pricereactions
to negativeearnings(see Ghosh et al. 2005; Bartovet al. 2002; Myers and Skinner2002; Skinnerand Sloan
2002; Barthet al. 1999). Firmscan avoid earningssurprisesby manipulatingearningsto meet expectationsor
by guiding analyst expectationsto avoid overly optimisticforecasts.Althoughexisting studies suggest that
earningsmanagementdeclines with longerauditortenure(Myerset al. 2003; Johnsonet al. 2002), we do not
know whethertenureaffectsmanagers'propensityto guide analysts'expectations.
8 Ourcomputationof Tenurewill understatethe actuallengthof auditortenurebecause Tenureis 1 for firmsin
1982 even if the auditorwas the same for the prioryears.However,when we replicateour analysiscomputing
Tenurefrom 1974 using informationabout the client's auditoras reportedin Compustatbackfiles,similarto
Mansiet al. (2004), our conclusionsremainunaffected.
9 The use of alternativecut-off points such as 0.5 percentalso yields similar results, but it retainsextreme
observations.For instance,the minimumof E is -541 percentand the maximumof AE is 629 percentwhen
we delete the top and bottom0.5 percent.We delete observationswith absoluteCARsgreaterthan 100 percent
to reducethe impactof majorcorporaterestructuringactivitiessuch as mergers,bankruptcies,spin-offs,etc.
However,when we delete the top and bottom 1 percentof CAR,we get similarresults.The resultson tenure
are unaffectedwhen we truncatethe top and bottom 1 percentof observationsfor the controlvariables.
594 Ghoshand Moon
reporting. We avoid some of these biases by constructing a subsample in which the auditor-
client relationship lasts for at least five years. For auditor-client relationships lasting less
than five years, we delete all of the firm-year observations. The maximum number of
observations for the "restricted" sample is 35,826 firm-years.'0
Table I reports summary statistics for both the full sample (Panel A) and the restricted
sample (Panel B). We report the mean, minimum, first quartile, median, third quartile, and
maximum for Tenure, FirmAge, CAR, E, AE, Stock Rankings, Debt Ratings, and FEPS.
Auditor tenure is longer for the restricted sample than for the full sample; the mean/median
TABLE 1
Descriptive Statistics
Variables Mean Min 25% 50% 75% Max n
Panel A: Full Sample
Tenure(years) 8.549 1.000 5.000 8.000 12.000 19.000 38,794
FirmAge (years) 17.597 3.417 7.000 12.167 23.833 75.000 38,794
CAR -0.060 -0.991 -0.343 -0.108 0.158 0.999 38,794
E -0.007 -2.795 -0.022 0.048 0.083 0.523 38,794
AE 0.006 -1.418 -0.032 0.006 0.034 2.815 38,794
StockRankings 5.096 1.000 4.000 5.000 6.000 7.000 25,745
Debt Ratings 9.147 1.000 6.000 9.000 12.000 23.000 9,462
FEPS ($) 1.045 -4.140 0.450 0.890 1.490 7.250 16,417
Panel B: Restricted Sample
Tenure(years) 9.096 1.000 6.000 9.000 12.000 19.000 35,826
FirmAge (years) 18.004 3.417 7.000 12.750 24.000 75.000 35,826
CAR -0.054 -0.989 -0.332 -0.102 0.161 0.999 35,826
E 0.000 -2.795 -0.013 0.050 0.084 0.523 35,826
AE 0.006 -1.418 -0.030 0.006 0.033 2.804 35,826
StockRankings 5.055 1.000 4.000 5.000 6.000 7.000 24,216
Debt Ratings 9.087 1.000 6.000 9.000 12.000 23.000 9,060
FEPS ($) 1.049 -4.140 0.450 0.890 1.500 7.250 15,699
The full sampleincludesCompustatfirmswith availabledata from 1990 to 2000. The restrictedsampleconsists
of firmsin the full samplewith auditor-clientrelationshipslastingfor at least five years.Tenureis the duration
of the auditor-clientrelationshipin years startingfrom 1982. FirmAgemeasuresthe numberof yearsthatthe
firmhas been publiclytradedas of the fiscal year-end.CARis cumulativemarket-adjusted returnsfor the 12-
monthperiodendingthreemonthsafterthe fiscal year-end.Market-adjusted returnsare the differencebetween
raw returnsand value-weightedCRSP marketreturns.E is incomebeforeextraordinary items deflatedby market
value of equityat the beginningof the year.AE is the differencebetweenincomebeforeextraordinary items for
the currentyear and thatof last year deflatedby marketvalue of equityat the beginningof the year.Stock
Rankingsand Debt Ratingsrepresentnumericalvaluesof S&P commonstock rankingsand S&P seniordebt
ratings,respectively.StockRankings(Debt Ratings)are assigneda valueof I if a firm'sS&P commonstock
(seniordebt) is ratedas A+ (AAA), and as the S&P commonstock rankings(debt ratings)decline, the
numericalvalue increasesby 1. FEPS is the meanannualone-year-ahead earningsper shareforecastsfor year t
issued immediatelyfollowingthe earningsannouncementfor year t- 1.
0o Althoughwe use the Myers et al. (2003) methodologyto constructthe restrictedsample, the percentageof
observationsdeletedfrom the full sampleis much smallerin our study.One primaryreasonfor the difference
is thatwe includemanymore variablesin our analyses,which reducesthe size of our full sample.Thus,fewer
observationsare lost from requiringthatthe auditor-clientrelationshiplasts for at least five years in our study
relativeto those in Myerset al. (2003).
AuditorTenureand Perceptionsof Audit Quality 595
Tenurefor the full sample is 8.5/8 years, while the correspondingnumberfor the restricted
sample is 9.1/9 years. The mean FirmAgefor the full sample is 17.6 years, comparedto a
mean of 18.0 years for the restrictedsample. FirmAgeranges between 3.4 years and 75
years for the full and restrictedsamples.
The summarystatistics for CAR, E, and AE indicate few differences across the two
samples. The mean/medianCARfor the full sample is -0.060/-0.108, while thatfor the
restrictedsample is -0.054/-0.102.1 The mean/medianE for the full sample is -0.007/
0.048, comparedto a mean/medianof 0.000/0.050 for the restrictedsample. The mean/
medianAE is identicalfor the full and restrictedsamples (0.006).
Similarly,thereare almostno differencesin StockRankings,Debt Ratings,and earnings
forecasts(FEPS) betweenthe two samples.The averagefirmin both sampleshas a B S&P
common stock ranking(a numericalscore of 5), and a BBB S&P senior debt rating (a
numericalscore of about9). The mean/medianone-year-aheadanalysts'earningsper share
forecasts (FEPS) is $1.05/$0.89 and $1.05/$0.89 for the full and restricted samples,
respectively.
Table2 reportsthe Pearsoncorrelation(p) matrixbetween CAR,E, AE, StockRankings,
Debt Ratings, FEPS, Tenure, and FirmAge for the full sample. The high correlation between
Stock Rankings and Debt Ratings (p = 0.686) suggests that stock rankings and debt ratings
issued by independentratingagenciescontainsignificantoverlappinginformation.However,
low correlationsacross variablesthat measureinvestor,ratingagency,and financialanalyst
perceptionsindicatethatanalysis of each marketparticipant'sperceptionsprovidesdistinct
insights into the overall perceptionsof the quality of accountinginformation.Finally,the
correlationbetween Tenureand FirmAgeis positive and statisticallysignificant(p = 0.337,
p-value = 0.001), which underscoresthe need to control for FirmAgewhen analyzing
Tenure.
V. RESULTS
All the regressionresultsreportedin Tables3 to 7 are based on yearlyregressionsfrom
1990 to 2000. The reportedcoefficients are the averageof 11 yearly coefficients,and the
correspondingt-statisticsare computedby comparingthe average coefficient to its time-
series standarderror.We preferthis approachto a pooled time-seriescross-sectionalesti-
mationbecausethe standarderrorsin the latterapproachare not adjustedfor the correlation
of regressionresidualsacross firms, which lead to inflatedt-statistics.The estimationpro-
cedure of year-by-yearcross-sectionalregressionsand the use of averageslopes and their
time-seriesstandarderrorsto draw inferencesallow for residualcross-correlation(for de-
tails, see Famaand French2000).
Perceptions of Investors and Auditor Tenure

In this subsection, we reportthe findings of how auditortenure affects the returns-
earningsassociation.Ourinterestis in the sign and magnitudeof the sum of the coefficients
on E*Tenureand E*Tenure(33 + 134).Consistentwith priorresearch,we find thatreported
earnings (E and AE) are significantly positively associated with returns (CAR) in Table 3.
The sum of the coefficients on E and AE, or ERC, is 0.507 (t-statistic = 10.30) in the first
" Priorstudiesalso find negativemean CAR:(1) DeFondand Hung (2003) reportthatthe mean CARmeasured
over fifteen monthsfor a sample of 21,908 observationsfrom 1993 to 1999 is -0.05 (-0.04) for firms with
(without)I/B/E/S cash flow forecasts;(2) Subramanyam and Wild (1996) find that the mean CARover one
quarterfor a sampleof 25,160 observationsfrom 1981 to 1990 is -0.01; and (3) Ali andZarowin(1992) report
that the mean 12-monthCARfrom 1970 to 1985 is -0.05 (-0.04) for the transitory(permanent)groupwith
4,355 (7,219) observations.
596 Ghosh and Moon
TABLE2
PearsonCorrelationMatrix
Variables 1 2 3 4 5 6 7 8
1. CAR 1.000
2. E 0.262 1.000
(0.001)
3. AE 0.194 0.368 1.000
(0.001) (0.001)
4. Stock Rankings -0.118 -0.266 0.068 1.000
(0.001) (0.001) (0.001)
5. Debt Ratings -0.185 -0.341 -0.028 0.686 1.000
(0.001) (0.001) (0.004) (0.001)
6. FEPS -0.002 0.021 -0.003 -0.007 -0.080 1.000
(0.802) (0.001) (0.652) (0.391) (0.001)
7. Tenure 0.112 0.122 0.015 -0.169 -0.201 0.024 1.000
(0.001) (0.001) (0.001) (0.001) (0.001) (0.001)
8. FirmAge 0.093 0.115 0.010 -0.291 -0.428 0.025 0.337 1.000
(0.001) (0.001) (0.026) (0.001) (0.001) (0.001) (0.001)
Pearsoncorrelationmatrixfor the full sample.CARis cumulativemarket-adjusted returnsfor the 12-month
periodendingthreemonthsafterthe fiscal year-end,wheremarket-adjusted returnsare the differencebetween
raw returnsand value-weightedCRSP marketreturns.E is incomebeforeextraordinary items deflatedby market
value of equityat the beginningof the year.AE is the differencebetweenincomebeforeextraordinary items for
the currentyear and thatof last year deflatedby marketvalue of equityat the beginningof the year.Stock
Rankingsand Debt Ratingsrepresentnumericalvaluesof S&P commonstock rankingsand S&P seniordebt
ratings,respectively.StockRankings(Debt Ratings)are assigneda valueof 1 if a firm'sS&P commonstock
(seniordebt) is ratedas A+ (AAA), and as the S&P commonstock rankings(debtratings)decline,the
numericalvalue increasesby 1. FEPS is the meanannualone-year-ahead earningsper shareforecastsfor year t
issued immediatelyfollowingthe earningsannouncementfor year t- 1. Tenureis the durationof the auditor-
client relationshipin yearsstartingfrom 1982. FirmAgemeasuresthe numberof years thatthe firmhas been
publiclytradedas of the fiscal year-end.
The p-valuesfor correlationcoefficientsare reportedin parentheses.
regressionwithoutthe control variablesusing the full sample. More important,33 + 34 is

positive and significant(0.012, t-statistic= 3.45). Regressionestimatesindicatethat inves-
tors on averagepay a premiumof 2.4 percent(= 0.012/0.507) for earningsas the auditor-
client relationshipincreases by an additionalyear. The coefficient on Tenure(13) is also
significant(0.005, t-statistic = 4.06), indicatingthat auditortenureis positively associated
with returns.
The ERC is 0.432 (t-statistic = 9.00) in the second regression when we include a
numberof control variables. 133+ 34 remains positive and significant (0.008, t-statistic
= 2.48). The parameterestimates suggest that, aftercontrollingfor the otherdeterminants
of ERC, investorspay a premiumof 2 percent(= 0.008/0.432) for earningsas the audit
engagement increases by an additionalyear. Even though the magnitudeof + 4 is
smaller in the second regression,we find it reassuringthat the results continue133to be sig-
nificant even after including many control variables. When we estimate the augmented
model using the restrictedsample for which the auditor-clientrelationshiplasts for at least
five years, we find similarresults. Specifically,13 + 13 is positive and significantat the 5
percentlevel (0.008, t-statistic= 2.03) in the thirdregression.
The parameterestimatesof the componentsof ERCprovideaddedinsightsinto investor
perceptionsof the time-seriespropertiesof earnings.The coefficients on E and AE in all
threeregressionsare positive and significantat the 1 percentlevel. Consideringthatearnings

levels (earningschanges) are more importantfor pricing decisions when earningscontain
transitory(permanent)components(Easton and Harris 1991; Ali and Zarowin 1992), the
results suggest that investorsview reportedearningsas containingboth transitoryand per-
manent components. Individual coefficients on E*Tenure (13) and AE*Tenure (14) also
TABLE 3
Earnings Response Coefficients and Perceptions of Investors
Full Sample
Variables (Coefficients) (1) (2) Restricted Sample
Intercept (a) -0.037 (-5.82)*** -0.096 (-6.40)*** -0.088 (-5.87)***
E (P31) 0.356 (6.91)*** 0.261 (4.51)*** 0.195 (2.92)***
AE (12) 0.151 (8.09)*** 0.171 (5.04)*** 0.232 (5.60)***
(13P+ 12)
0.507 (10.30)*** 0.432 (9.00)*** 0.427 (7.09)***
E*Tenure (P3) 0.007 (2.49)** 0.006 (1.80)* 0.009 (2.18)**
AE*Tenure (134) 0.005 (3.39)*** 0.002 (1.34) -0.001 (-0.78)
(13 + 13) 0.012 (3.45)*** 0.008 (2.48)** 0.008 (2.03)**
Tenure (13) 0.005 (4.06)*** 0.003 (5.68)*** 0.003 (5.29)***
ControlVariables
E*FirmAge (36)/AE*FirmAge (7,)
(P6 + P7) -0.002 (-1.75) -0.002 (-1.71)
E*Big4 (38)/AE*Big4 (13)
+ -0.091 (-2.25)** -0.117 (-2.11)**
(138 139)
E*Growth (P,0)/AE*Growth (,11)
(13o + 13,1) 0.023 (1.35) 0.035 (1.92)*
E*Persistence (P132)/
AE*Persistence
(,33)
(P12 + 1313) 0.084 (2.42)** 0.079 (2.19)**
E*Volatility (P34)/AE*Volatility (P315)
(P114 + 1315)
-0.083 (-7.40)*** -0.092 (-7.52)***
E*Beta (P16)IAE*Beta
(137)
(1316 + 1317)
-0.061 (-1.87)* -0.070 (-1.99)*
E*Size (P,8)/AE*Size (1319)
(1318
+ ,19) 0.119 (9.27)*** 0.132 (8.79)***
E*Leverage (P20)/AE*Leverage (321)
(1320 + 21) -0.290 (-4.74)*** -0.296 (-4.21)***
E*Regulation (P322)/AE*Regulation(1323)
(P22 + 323) -0.061 (-1.38) -0.051 (-1.27)
FirmAge (124) 0.001 (4.58)*** 0.001 (4.47)***
Big4 (P25) 0.047 (4.00)*** 0.041 (3.43)***
Growth (P26) 0.023 (5.41)*** 0.024 (5.60)***
Persistence (P27) 0.014 (1.93)* 0.015 (2.28)**
Volatility (1328) -0.025 (-7.75)*** -0.025 (-8.53)***
Beta (129)
-0.005 (-0.18) -0.003 (-0.10)
Size (030) -0.005 (-1.23) -0.005 (-1.39)
Leverage (P31) -0.018 (-0.71) -0.014 (-0.53)
Regulation (1332) 0.045 (4.01)*** 0.044 (3.72)***
YearlyObservations 3,044-4,122 3,044-4,122 2,897-3,803
AdjustedR2 0.039-0.162 0.111-0.372 0.109-0.369
(continued on next page)
598 Ghosh and Moon
TABLE 3 (continued)
*, **, and *** denote statisticalsignificanceat the 0.10, 0.05, and 0.01 level, respectively,for a two-tailedtest.
of firmsin the full samplewith auditor-clientrelationshipslastingfor at least five years.The dependentvariable
is cumulativemarket-adjusted returnsfor the 12-monthperiodendingthreemonthsafterthe fiscal year-end
(CAR).Market-adjusted returnsare the differencebetweenraw returnsand value-weightedCRSP marketreturns.
E is incomebeforeextraordinary items deflatedby marketvalue of equityat the beginningof the year.AE is the
differencebetweenincomebeforeextraordinary items for the currentyear and thatof last year deflatedby
marketvalue of equity at the beginningof the year.Tenureis the durationof the auditor-clientrelationshipin
years startingfrom 1982. We suppressthe individualcoefficientson E*controlvariableand AE*controlvariable;
instead,we reportthe sum of the two coefficients.The controlvariablesare definedas follows: FirmAge
measuresthe numberof years thatthe firmis publiclytradedas of the fiscal year-end;Big4 is an indicator
variablethatequals 1 when the client's auditoris a largeaccountingfirm;Growthis the sum of the market
value of equityand the book valueof debt scaled by the book valueof total assets;Persistence(Volatility)is the
first-orderautocorrelation (standarddeviation)of incomebeforeextraordinary items per sharefor the past 16
quarters;Beta is the systematicrisk computedusing the past 60 monthlystock returns;Size is the logarithmic
transformation of the fiscal year-endmarketvalue of equityof the prioryear;Leverageis the ratioof total debt
to total assets;and Regulationis an indicatorvariablethatequals 1 for firmsin a regulatedindustrywith two-
digit SIC codes between40 and 49 or between60 and 63, otherwiseit equals0.
The reportedcoefficientsare the averageof yearlycoefficientsfrom 1990 to 2000, and the correspondingt-
statisticsin parenthesesare basedon the distributionof the yearlycoefficients.
provide some insights:(1) P3 is largerthan 34 in all three regressions;and (2) P3 is statis-

tically significant in all three regressions at the 10 percent level or below, while P4 is
significantin only one regression.The incrementalimportanceof earningslevels in pricing
decisions suggests that, as the auditor-clientrelationshiplengthens, investorsperceive re-
portedearningsas being more transitory.
We briefly discuss the results of the control variablesbecause they have been exten-
sively analyzed in prior studies (Subramanyamand Wild 1996; Warfieldet al. 1995;
Dhaliwal and Reynolds 1994; Collins and Kothari1989). To conserve space, we do not
reportthe individualcoefficientson the interactionsbetween each control variableand El
AE. Instead, we reportthe sum of the two interactioncoefficients. Controllingfor other
determinantsof ERC, our resultsbased on the restrictedsample suggest that the ERC does
not vary with FirmAge(P36+ P7 is insignificant).Since 13 + P9 is negativeand significant,
our results indicate that the ERC is lower for client firms of large auditingfirms (Big4),
which is inconsistentwith the findingsof Teoh and Wong (1993). As in priorstudies, we
find that the ERC is positively associated with Growth,Persistence,and Size, and is neg-
atively associated with Volatility, Beta, Leverage, and Regulation. Also, the coefficients on
FirmAge, Big4, Growth, Persistence, Volatility, and Regulation are all significant at the 5
percentlevel or below.
Bias in the EstimatedERCfrom Prices Leading Earnings
A potential concern in Table 3 is that the estimated ERC from a contemporaneous
returns-earningsregressionmightbe biased downwardif the marketanticipatescurrentyear
earnings more than one year prior to the earnings release (Kothari 1992; Kothari and Sloan
1992). The estimated ERC could be biased from using a 12-month contemporaneous period
to computereturnsor from using marketvalue of equity as a deflator.12Further,the down-

wardbias in the estimatedERC is expected to be largerfor firmswith longer tenure.Given
that prior studies generally find that earningsquality improveswith extended tenure,and
considering that high-qualityearnings are easier to predict, the marketis more likely to
anticipatecurrent-yearearningsfor firms with longer tenure.
We mitigate potentialbiases in the estimatedERC in two ways. First, as in DeFond
and Hung (2003) and Collins and Kothari(1989), we measurereturnsover a 15-month
period ending three months after the fiscal year-end.Increasingthe returnsmeasurement
window enhances the probabilityof including the period in which the marketanticipates
currentearnings thereby reducing any measurementerror. Second, as in Subramanyam
(1996), we deflate earningsby total assets at the beginningof the year. Since total assets
are typically based on historicalcost ratherthan marketvalue, any bias in the estimated
coefficients from prices leading earningsis likely to be reducedfrom using total assets as
a deflator.
Panel A of Table 4 reportsthe results from using cumulativemarket-adjusted returns
measuredover 15 months (CAR5-m,,onth) as the dependentvariable.While the magnitudeof
ERC (p, + 32) is smaller,we find that the size of the sum of the coefficientson E*Tenure
and AE*Tenure(A3 + 34) is 25 to 38 percent larger than that reportedin Table 3. One
reason why the ERC is smaller may be because of the large numberof control variables.
When we estimate the regressionsin Panel A without the control variables,we find that
the estimatedERC becomes larger.Specifically,unreportedresults show that the ERC for
the full sample withoutthe control variablesis 0.568, while the correspondingestimate is
0.507 in Table 3.
We find similar results using total assets as a deflatorfor E and AE. The estimate of
+
P3 14 using the full (restricted)sample is 0.027 (0.025) in Panel B of Table4, while the
correspondingestimate in Table 3 is 0.008 (0.008). Thus, the magnitudeof P3 + 34 is 213
to 238 percentlargerin Panel B comparedto that reportedin Table 3. The magnitudeof
ERC is also largerin Panel B than that in Table 3. Hence, the results in Table4 suggest
that investorsare more likely to anticipatecurrent-yearearningsmore thanone year ahead
of the earningsrelease for firms with extendedauditor-clientrelationships.
Overall,the resultsfromTables3 and 4 are consistentwith the hypothesisthatinvestors
perceive earningsquality as improvingwith longer auditortenure.Our results suggest that
investorsview audit quality as improvingwith auditortenure.
Perceptions of Information Intermediaries and Auditor Tenure

S&P Stock Rankings and Debt Ratings
Unlike stock returns,stock rankingsand debt ratingsare possibly correlatedover time.
Therefore,the residualsfrom yearly regressionsmay not be independent,which could lead
to biased t-statistics.We compute an autocorrelation-correctedt-statistic(t-statisticAc) by
comparingthe mean coefficientswith the time-series-basedstandarderrorthat accountsfor
2 If prices lead earnings, current period earnings contain information that is "new" to the market and information
that is "stale" or "old." Given that stock prices change in response to new information, the independent variable
contains errors of measurement from using current period earnings as the regressor (also known as errors-in-
variable problem). Measurement error on the independent variable biases the slope coefficient downward because
of its correlation with the regression disturbance term (Greene 1993). Similarly, deflating earnings by market
value of equity might inject a downward bias in the estimated coefficients when the market anticipates current
period earnings at the beginning of the year.
600 Ghosh and Moon
TABLE 4
Earnings Response Coefficients and Perceptions of Investors: Sensitivity Analysis
Variables (Coefficients) Full Sample Restricted Sample
Panel A: CARlS-month is the Dependent Variable
E (P13) 0.217 (2.62)** 0.165 (1.95)*
AE (12) 0.169 (3.80)*** 0.248 (4.07)***
+ 0.386 (5.50)*** 0.413 (5.21)***
(13 32)
E*Tenure (P3) 0.008 (1.65) 0.011 (1.92)*
AE*Tenure (14) 0.003 (1.30) -0.001 (-0.91)
+ 0.011 (2.84)*** 0.010 (2.24)**
(13P 14)
Tenure (Ps) 0.004 (5.99)*** 0.003 (5.37)***
Control Variables (as in Table 3) Included Included
Yearly Observations 3,044-4,122 2,897-3,803
Adjusted R2 0.145-0.322 0.154-0.327
Panel B: Earnings are Scaled by Total Assets

E (P31) 0.415 (5.06)*** 0.393 (5.09)***
AE 0.379 (3.99)*** 0.468 (3.69)***
(132)
+ 0.794 (8.33)*** 0.861 (8.57)***
(P, 132)
E*Tenure (13) 0.006 (0.84) 0.012 (1.16)
AE*Tenure (134) 0.021 (2.46)** 0.013 (1.58)
+ N4) 0.027 (2.41)** 0.025 (2.38)**
(13
Tenure (13) 0.002 (2.68)** 0.001 (0.94)
ControlVariables(as in Table3) Included Included
Yearly Observations 3,218-4,207 3,063-3,888
Adjusted R2 0.095-0.278 0.091-0.288
*, **, and *** denotestatisticalsignificanceat the 0.10, 0.05, and 0.01 level, respectively,for a two-tailedtest.
The full sampleincludesCompustatfirmswith availabledatafrom 1990 to 2000. The restrictedsampleconsists
of firmsin the full samplewith auditor-clientrelationshipslastingfor at least five years.In PanelA, the
dependentvariableis cumulativemarket-adjusted returnsfor the 15-monthperiodendingthreemonthsafterthe
fiscal year-end(CARIs-mo),,.Market-adjusted returnsare the differencebetweenraw returnsand value-weighted
CRSP marketreturns.E is incomebeforeextraordinary items deflatedby marketvalue of equity at the
beginningof the year.AE is the differencebetweenincomebeforeextraordinary items for the currentyear and
thatof last year deflatedby marketvalue of equity at the beginningof the year.In PanelB, the dependent
variableis CARmeasuredover the 12-monthperiodendingthreemonthsafterthe fiscal year-end.E is income
beforeextraordinary items deflatedby total assets at the beginningof the year.AE is the differencebetween
incomebeforeextraordinary items for the currentyear and thatof last year deflatedby total assets at the
beginningof the year.The resultsof all the controlvariablesin PanelsA and B are not reportedfor brevity.
The reportedcoefficientsare the averageof yearlycoefficientsfrom 1990 to 2000, and the corresponding
t-statisticsin parenthesesare based on the distributionof the yearlycoefficients.
any dependence in the estimated coefficients, as in Abarbanell and Bernard (2000).'" Since
13 We assumethatserialcorrelationis second-orderautoregressive,so thatthe correctioninvolvesmultiplyingthe

2*r*( - r)
standard the factor where n is the number of observations used
yearly er ors by (1+r)
[(1 - r)] -
r)2
[-[n*(1
estimated
to computethe mean coefficientand r is the averageof the first-and second-orderautocorrelations
r
fromthe seriesof annualcoefficients.The correctionfactoris not appliedwhenestimatedautocorrelationis less

thanzero.
our focus is on auditor tenure, we compute t-statisticACfor coefficients that involve Tenure
only.
Table 5 reports the regression results of common stock rankings on auditor tenure. The
first column in Table 5 presents the results from the reduced model using the full sample.
TABLE 5
Stock Rankings and Perceptions of Information Intermediaries
Full Sample
Intercept (a) 5.746 (100.31)*** 6.610 (140.79)*** 6.614 (149.22)***
E (P31) -1.969 (-5.25)*** -0.208 (-0.91) -0.366 (-1.01)
AE (P2) 1.314 (4.77)*** -0.148 (-0.58) -0.030 (-0.08)
(P1 + 32)
-0.655 (-5.25)*** -0.356 (-2.03)** -0.396 (-1.84)*
E*Tenure (13) -0.100 (-3.80)*** -0.061 (-5.16)*** -0.063 (-5.87)***
AE*Tenure (N4) 0.046 (2.39)** 0.021 (1.93)* 0.023 (1.96)*
(13 + 14) -0.054 (-3.76)*** -0.040 (-3.31)*** -0.040 (-2.97)***
Tenure (Ps) -0.068 (-6.05)*** -0.023 (-9.33)*** -0.024 (-9.79)***
Control Variables
E*FirmAge (36)/AE*FirmAge (,7)
+ 37) 0.017 (2.45)** 0.021 (2.72)**
(136
E*Big4 (P,)/IAE*Big4 (P,)
(138+ 39) 0.264 (2.54)** 0.262 (2.61)**
E*Growth(Po)/AE*Growth(P1,)
-0.134 (-1.66) -0.158 (-1.77)
(13o + P11)
E*Persistence (P3l2)/AE*Persistence
(1313)
(P312 + 13) 0.536 (3.40)*** 0.625 (4.23)***
E*Volatility (P14)/AE*Volatility (P35)
(314 + P15)
0.189 (2.60)** 0.193 (2.64)**
E*Beta (pl16)/AE*Beta (137)
0.265 (4.21)*** 0.320 (3.79)***
(P16+ 137)
E*Size (318)/AE*Size (p,,)
+ 1319) -0.208 (-4.40)*** -0.226 (-4.09)***
(138
E*Leverage (320)/AE*Leverage (1321
(120
+ 21) 0.489 (2.62)** 0.438 (1.83)*
E*Regulation (P322)/AE*Regulation(323)
(P22 + 323) 0.038 (0.28) 0.040 (0.24)
FirmAge (124)
0.001 (0.88) 0.000 (0.46)
Big4 (P25) 0.250 (11.51)*** 0.256 (14.51)***
Growth (P26) 0.033 (2.66)** 0.030 (3.19)***
Persistence (127)
-0.032 (-0.79) -0.023 (-0.53)
Volatility (128) 0.309 (15.93)*** 0.329 (15.88)***
Beta (129) 0.372 (8.71)*** 0.373 (9.44)***
Size (130) -0.375 (-26.10)*** -0.371 (-24.15)***
Leverage (P31) 0.407 (5.77)*** 0.396 (5.63)***
Regulation (P32) -0.207 (-6.00)*** -0.205 (-6.10)***
YearlyObservations 2,019-2,637 2,019-2,637 1,949-2,487
AdjustedR2 0.125-0.169 0.463-0.523 0.448-0.519
602 Ghoshand Moon
TABLE 5 (continued)
*, **, and *** denotestatisticalsignificanceat the 0.10, 0.05, and 0.01 level, respectively,for a two-tailedtest.
is S&P commonstock rankingsconvertedinto numericalvalues (StockRankings).StockRankingstake the
valuesof 1 to 7 representingS&P commonstock rankingsof A+, A, A-, B+, B, B-, and C, respectively.
Tenureis the durationof the auditor-clientrelationshipin years startingfrom 1982. E is incomebefore
extraordinary items deflatedby marketvalue of equity at the beginningof the year.AE is definedas the
marketvalueof equityat the beginningof the year.We suppressthe individualcoefficientson E*control
variableand AE*controlvariable;instead,we reportthe sum of the two coefficients.The controlvariablesare
definedas follows: FirmAgemeasuresthe numberof years thatthe firmis publiclytradedas of the fiscal year-
end; Big4 is an indicatorvariablethatequals I when the client's auditoris a largeaccountingfirm;Growthis
the sum of the marketvalueof equity and the book value of debt scaledby the book value of total assets;
Persistence(Volatility)is the first-orderautocorrelation (standarddeviation)of incomebeforeextraordinary items
per sharefor the past 16 quarters;Beta is the systematicrisk computedusing the past 60 monthlystock returns;
Size is the logarithmictransformation of the fiscal year-endmarketvalueof equityof the prioryear;Leverageis
the ratioof total debt to total assets;and Regulationis an indicatorvariablethatequals 1 for firmsin a regulated
industrywith two-digitSIC codes between40 and 49 or between60 and 63, and 0 otherwise.
t-statisticsin parenthesesare basedon the distributionof the yearlycoefficients.
As in Table3, ERC,a proxyfor earningsqualityas perceivedby ratingsagencies, is defined

as the sum of the coefficientson E and AE.'4 The ERC is negative(-0.655) and statistically
significantat the 1 percentlevel (t-statistic = -5.25). P3 + 34, which measuresthe joint
effects of tenureand earningson rankings,is also negative (-0.054) and significantat the
1 percent level (t-statistic = -3.76; t-statisticAc = -3.14). All else equal, for a given
increase in earnings, Stock Rankings improve by an additional8.2 percent (= -0.054/
-0.655) when the audit engagementincreasesby an added year.
The coefficient on Tenure(13) is negative (-0.068) and significantat the 1 percent
level (t-statistic= -6.05; t-statisticAC= -3.52). Otherthingsremainingconstant,if auditor
tenurefor a firmis one standarddeviationabove the meanvalue of Tenure,the stock ranking
is lower by 0.327 (= -0.068 x 4.807), comparedto the average stock rankingof 5.096
for the sample used in the regression.
The second column in Table 5 reportsthe resultsfrom the augmentedmodel using the
full sample. P3 + 34 remains negative (-0.040) and significant (t-statistic = -3.31;
t-statisticA = -3.31). 13 is also negative (-0.023) and significant (t-statistic = -9.33;
t-statisticAC= -6.59). The results are very similar when we use the restrictedsample
(reportedin the last column). P3 + 134is negative (-0.040) and significant(t-statistic =
-2.97; t-statisticAC = -2.97), and P, is highly significant(-0.024, t-statistic = -9.79;
t-statisticAC= -6.78). Our results suggest that rating agencies place a greaterweight on
reportedearningsas auditortenure increases.Given that S&P incorporatesthe quality of
accountinginformationas a factor in establishingits rankings/ratings(Standard& Poor's
1982), the importanceof tenuresuggests that,as tenureincreases,independentratingagen-
cies perceive audited financial statements as being more reliable.
We briefly discuss how various control variables affect Stock Rankings (based on the
full sample). The coefficients on the interactions between earnings and FirmAge, Persist-
ence, Volatility, Beta, and Leverage are positive and significant at the 5 percent level or
"
Althoughthe term ERC or earningsresponsecoefficientis typicallyused for earningscoefficientsin returns-
earningsregressions,we use the termin a broadercontextto referto earningscoefficientsfor the returns,stock
rankings,debt ratings,and analystforecastsregressions.
below. These results suggest that the effect of earnings on Stock Rankingsis smaller for
mature/riskyfirms.The positive sign of the coefficienton the interactionsbetweenearnings
and Big4 (38 + P,) is puzzling. The coefficient on the interactionsbetween earningsand
Size (1,s + .19)is negativeand significantat the 1 percentlevel, indicatingthat the effect
of earningson StockRankingsis largerfor bigger firms.The coefficientson the interactions
between earningsand Growth(P13o + P1,) and those between earningsand Regulation(122
+ are both insignificant.
323)
The control variablesare also includedas separateindependentvariables.The positive
sign of the coefficient on Big4 is again puzzling. The coefficients on Volatility,Beta, and
Leverageare all positive and significant,which suggests thathigherrisk has an unfavorable
impacton stock rankings.The coefficienton Growthis also positive, which is inconsistent
with our expectations.If our model does not adequatelycontrol for risk, growth firms are
more likely to be associatedwith unfavorableStockRankingsbecause highergrowthcould
proxy for largerrisk. The coefficientson Size and Regulationare negative,which suggests
that stock rankingsare more favorablefor largerfirms and those in regulatedindustry.The
coefficientson FirmAgeand Persistenceare insignificant.
Table 6 presents the regression results of the association between debt ratings and
auditortenure.The first column in Table 6 presentsthe results of estimatingthe reduced
model using the full sample. Consistentwith priorresearch,the ERC is negative and sig-
nificant (-4.568, t-statistic = -5.87). Thus, earningshave a favorableinfluence on debt
ratings.The sum of the coefficientson E*Tenureand AE*Tenure(A3 + 34) is also negative,
but insignificant(-0.093, t-statistic = - 1.03; t-statisticAC= -0.98). In contrast,the coef-
ficient on Tenure(P3) is negative and significant(-0.183, t-statistic = -6.33; t-statisticAC
- -3.42), consistentwith the findingsof Mansi et al. (2004).
Once we include the control variablesin Table6, the ERC is insignificantin eitherthe
second or the thirdregression.AlthoughP3 + 34 is marginallysignificant(-0.216, t-statistic
= -1.98; t-statisticAc = -1.85) for the full sample, it is insignificant (-0.240, t-statistic
S-1.66; t-statisticAc= -1.62) for the restrictedsample. On the other hand, P, remains
negative and significant for the full sample (-0.065, t-statistic = -4.78; t-statisticAC
= -2.70) and the restricted
sample (-0.067, t-statistic = -4.51; t-statisticAc= -2.70).
Thus, althoughlonger tenureis associatedwith improveddebt ratings,the associationbe-
tween earningsand debt ratingsdoes not appearto vary with tenure.'5
In a recent study, Mansi et al. (2004) find that auditortenure is negatively relatedto
the cost of debt and that the relation is more pronouncedfor non-investment-grade debt.
This findingsuggests that auditortenurecould influencedebt ratingsdifferentlyfor invest-
ment and non-investment-grade debt. FollowingMansiet al. (2004), we separatelyestimate
the augmentedmodel for investmentand non-investment-grade debt to investigatewhether
the impact of auditortenure on debt ratings depends on the quality of debt. When we
partitionour sample into investmentand non-investment-grade debt subsamples,the results
are very similar to those reportedin Table 6. For example, P3 + 34 is negative but not
significantin either subsample,but P3 is negativeand significantfor both subsamples(for
brevity, the results are not tabulated).
In sum, the regression results from stock rankings and debt ratings provide modest
evidence that independent rating agencies perceive firms with longer auditor tenure as
providing more reliable financial information.
'~5Since the same controlvariablesappearin the stock rankingsand debt ratingsregressions,and the resultsare
similaracrossthetwosetsof regressions,
we do notrepeatourdiscussionof thecontrolvariables
forthedebt
ratings regressions.
604 Ghosh and Moon
Financial Analysts' Earnings Forecasts

Table 7 reportsthe results of how auditortenureaffects the associationbetween one-
year-aheadconsensusearningsper shareforecastsand earningsper sharereportedjust prior
to the forecasts.As in the previoustables, our interestis in the sum of the coefficientson
*
EPS,_ Tenure and AEPS,_,*Tenure (33 + 14). The first column in Table 7 reportsthe
TABLE 6
Debt Ratings and Perceptions of Information Intermediaries
Full Sample
Intercept (a) 11.101 (64.35)*** 14.387 (42.74)*** 14.032 (31.54)***
E (P13) -8.796 (-3.37)*** -1.378 (-0.21) 2.596 (0.40)
AE (12) 4.228 (2.13)** 14.567 (1.13) 11.871 (0.88)
(p, + 32) -4.568 (-5.87)*** 13.189 (1.02) 14.467 (1.13)
E*Tenure (133) -0.169 (-0.84) 0.014(0.18) 0.020 (0.22)
AE*Tenure (34) 0.076 (0.54) -0.230 (-2.06)** -0.260 (-1.89)*
(p3 + 34) -0.093 (-1.03) -0.216 (-1.98)* -0.240 (-1.66)
Tenure (135) -0.183 (-6.33)*** -0.065 (-4.78)*** -0.067 (-4.51)***
ControlVariables
E*FirmAge (36)/AE*FirmAge (7,)
(136+ 137) 0.040 (3.11)*** 0.040 (2.63)**
E*Big4 (P8)/AE*Big4 (39)
+
(138 139)
- 13.630 (-1.05) -15.302 (-1.17)
E*Growth (1,o)/AE*Growth (31,)
+ 1.333 (1.61) 1.641 (1.54)
(P3o 1311)
E*Persistence (P12)/ AE*Persistence (P,3)
(P12 + 1.284 (3.17)*** 1.280 (2.97)***
P-13)
E*Volatility (P,4)IAE*Volatility
(134 +
115)
(P•5) 0.068 (0.57) 0.114 (0.67)
E*Beta (P16)/AE*Beta
(P137)
(1P16
+ ,17) 1.011 (2.11)** 1.083 (2.26)**
E*Size (P,,)/AE*Size (p,,)
(138 + 1319) -0.594 (-2.67)** -0.552 (-2.25)**
E*Leverage (320)/AE*Leverage (321)
+ 21) 0.449 (0.29) 0.512 (0.32)
(1320
E*Regulation (1322)/AE*Regulation(1323)
(P22 + 123) -1.127 (-1.84)* -1.271 (-1.99)*
FirmAge (324)
-0.014 (-7.46)*** -0.014 (-7.13)***
Big4 (325) 1.473 (3.13)*** 1.914 (3.80)***
Growth (326)
-0.102 (- 1.94)* -0.108 (-1.98)*
Persistence (127)
0.306(4.78)*** 0.305(4.60)***
Volatility (328)
0.254(7.55)*** 0.223(5.36)***
Beta (129)
1.359(12.12)*** 1.333(11.66)***
Size (130)
-1.087 (-31.65)*** -1.088 (-29.81)***
Leverage (131) 3.676 (13.00)*** 3.663 (12.30)***
Regulation (332)
- 1.025 (- 10.18)*** -1.017 (-10.20)***
YearlyObservations 603-1,124 603-1,124 598-1,051
AdjustedR2 0.132-0.245 0.602-0.699 0.596-0.697
TABLE 6 (continued)
*, *, and *** denote statisticalsignificanceat the 0.10, 0.05, and 0.01 level, respectively,for a two-tailedtest.
The full sampleincludesCompustatfirmswith availabledatafrom 1990 to 2000. The restrictedsampleconsists
is S&P seniordebt ratingsconvertedinto numericalvalues (Debt Ratings).Debt Ratingsare assigneda value of
I if a firm'sS&P seniordebt is ratedas AAA. As the S&P debt ratingsdecline, the numericalvalue increases
by 1. Tenureis the durationof the auditor-clientrelationshipin years startingfrom 1982. E is income before
extraordinary items deflatedby marketvalue of equity at the beginningof the year.AE is definedas the
marketvalue of equityat the beginningof the year.We suppressthe individualcoefficientson E*control
variableand AE*controlvariable;instead,we reportthe sum of the two coefficients.The controlvariablesare
definedas follows: FirmAgemeasuresthe numberof yearsthat the firmis publiclytradedas of the fiscal year-
end; Big4 is an indicatorvariablethatequals 1 when the client's auditoris a largeaccountingfirm;Growthis
the sum of the marketvalue of equityand the book value of debt scaled by the book valueof total assets;
Persistence(Volatility)is the first-orderautocorrelation (standarddeviation)of incomebeforeextraordinary items
Size is the logarithmictransformation of the fiscal year-endmarketvalue of equityof the prioryear;Leverageis
the ratioof total debt to total assets;and Regulationis an indicatorvariablethatequals 1 for firmsin a regulated
industrywith two-digitSIC codes between40 and 49 or between60 and 63, and 0 otherwise.
results of the reducedmodel for the full sample. We find that reportedearningsare posi-
tively associatedwith analysts'earningsforecasts.The ERC (3, + 32)is positiveand highly
significant(1.008, t-statistic = 20.29). Moreover,133+ 34 is also positive and significant
(0.019, t-statistic= 2.68). Otherthings remainingconstant,our resultssuggest thatanalysts
appearto attachgreaterimportanceto the most recent reportedearningsin forming their
expectationsabout futureearningsas auditortenuregrows longer.
When we estimate the augmentedmodel that includes a numberof control variables,
P3 + remainspositive and significant(0.016, t-statistic= 2.90) in the second regression.
34
The results are very similar when we estimate the augmentedmodel using the restricted
sample. 33 + 34 continues to be positive and significant in the third regression (0.016,
t-statistic= 2.51). On the other hand, 13 is insignificantin all three regressions.
The individualparameterestimatesof ERC and 13 + 34 provide some added insights.
The coefficients on EPS,_, and AEPS,_ (12) are both significant in the first regression.
However,in the second and thirdregressionsthatincludethe otherdeterminantsof earnings
(0•)
forecasts, 32 becomes insignificant.Largeearningssurprisesare morelikely to be temporary
and, therefore,potentiallyless useful to analysts in predictingfuture earnings (Barronet
al. 2002; Stickel 1989). In contrast,the coefficienton AEPS,_,*Tenure(13) is significantin
all threeregressionsat the 10 percentlevel or below. The resultssuggest thatalthoughpast
earningschanges do not influenceearningsforecasts,they are perceivedas more relevant
for earningsforecastsas the auditor-clientrelationshipincreases.
Based on the results from the restrictedsample, we briefly discuss how the various
control variables affect analysts' earnings forecasts (FEPS,). The coefficients on the inter-
actions between reported earnings and FirmAge, Leverage, and Analysts are all negative
and significant at the 10 percent level or below. These results suggest that the effect of
reported earnings on FEPS, is smaller for mature/risky firms and for firms with larger
analyst following. The interaction between reported earnings and Size is positive and sig-
nificant, which suggests that the impact of reported earnings on analysts' earnings forecasts
is greater for bigger firms. Also, the individual coefficients on FirmAge, Volatility,Leverage,
and Analysts are all positive and significant at the 5 percent level or below, which suggests
606 Ghoshand Moon
that analysts' earnings forecasts are higher for mature firms, for firms with higher risk, and
those with larger analyst following. The coefficient on Size is negative, which suggests that
earnings per share forecasts are smaller for bigger firms. One explanation is that large,
politically sensitive firms are more likely to report lower earnings to reduce their political
costs and, therefore, analysts' earnings forecasts are also lower for larger firms.
TABLE 7
Analyst Earnings Forecasts and Perceptions of Information Intermediaries
Full Sample
Intercept (a) 0.217 (8.84)*** 0.366 (15.47)*** 0.364 (14.87)***
EPS, , (13) 0.834 (22.34)*** 0.532 (15.28)*** 0.530 (15.64)***
AEPS,_, (132) 0.174 (4.59)*** -0.068 (-0.66) -0.074 (-0.70)
(p, + 32) 1.008 (20.29)*** 0.464 (4.62)*** 0.456 (4.49)***
EPS,_,*Tenure (133) 0.005 (1.75) 0.005 (1.79) 0.005 (1.54)
AEPS,_, *Tenure (34) 0.014 (2.00)** 0.011 (2.11)** 0.011 (1.95)*
(3, + 34) 0.019 (2.68)** 0.016 (2.90)*** 0.016 (2.51)**
Tenure (13) -0.000 (-0.15) -0.003 (-1.16) -0.002 (-0.76)
ControlVariables
EPS, ,*FirmAge (36)/AEPS,_ ,*FirmAge (,7)
(136+ P7) -0.004 (-2.83)*** -0.004 (-2.90)***
EPS, ,*Big4 (P,3)/AEPS, ,*Big4 (3,)
(13 + 13) -0.060 (-1.29) -0.077 (-1.49)
EPS,_ *Growth (3P,o)/AEPS,_,*Growth (P,,)
(A3o+ 3,,) -0.008 (-0.33) -0.010 (-0.41)
EPS, (P,2)/AEPS, *_*Volatility (P,3)
l*Volatility + P13) -0.032 (-0.67) -0.033 (-0.67)
(132
EPS, ,*Beta (1,4)I/AEPS,, ,*Beta (P3,)
(1314
+ 15) -0.011 (-0.37) -0.012 (-0.38)
EPS,_,*Size (p,6)IAEPS, ,*Size (,137)
(136
+ 1317) 0.140 (7.17)*** 0.147 (8.00)***
EPS,_ ,*Leverage (P,8)/AEPS,_ 1*Leverage (13,)
(p31 + P19) -0.235 (-2.18)** -0.225 (-1.99)*
EPS,_ , *Regulation (1320)/AEPS, , *Regulation (1321)
(P20 + 321)
-0.041 (-1.26) -0.034 (-1.04)
EPS,_, *Analysts (322)/ AEPS,_, *Analysts (1323)
(1322 + 23) -0.013 (-3.85)*** -0.014 (-4.20)***
FirmAge (324)
0.003 (4.92)*** 0.004 (4.95)***
Big4 (P325)
0.028 (1.39) 0.034 (1.54)
Growth (326)
-0.003 (-0.91) -0.003 (-1.00)
Volatility (127) 0.138 (3.04)*** 0.138 (2.86)***
Beta (328)
-0.004 (-0.28) -0.002 (-0.18)
Size (129)
-0.048 (-12.29)*** -0.050 (-12.99)***
Leverage (130) 0.174 (5.06)*** 0.168 (4.41)***
Regulation (P3,) 0.020 (0.89) 0.013 (0.55)
Analysts (332)
0.002 (1.82)* 0.002 (2.17)**
Yearly Observations 1,100-1,855 1,100-1,855 1,074-1,735
AdjustedR2 0.736-0.878 0.759-0.891 0.757-0.893
TABLE 7 (continued)
*, **, and *** denote statistical significance at the 0.10, 0.05, and 0.01 level, respectively, for a two-tailed test.
is the meanannualone-year-aheadearningsper shareforecastsfor year t issued immediatelyfollowingthe
earningsannouncementfor year t- 1 (FEPS,).EPS,_, is annualearningsper sharefor year t- 1, and AEPS,_, is
the absolutechangein earningsper sharefor year t- 1 definedas the differencein annualearningsper sharein
year t- 1 and that in year t-2 (IEPS,_,- EPS,_-2).All earningsper sharevariables(FEPS,,EPS,_.,,and
AEPS,_,)are obtainedfromI/B/E/S database.Tenureis the durationof the auditor-clientrelationshipin years
startingfrom 1982. All the controlvariablesincludingTenureare measuredas of the end of year t-1. We
suppressthe individualcoefficientson E*controlvariableand AE*controlvariable;instead,we reportthe sum of
the two coefficients.The controlvariablesare definedas follows: FirmAgemeasuresthe numberof years that
the firmis publiclytradedas of the fiscal year-end;Big4 is an indicatorvariablethat equals I when the client's
auditoris a largeaccountingfirm;Growthis the sum of the marketvalue of equityand the book value of debt
scaled by the book value of total assets; Volatilityis the standarddeviationof incomebeforeextraordinary items
Size is the logarithmictransformation of the fiscal year-endmarketvalue of equityof the prioryear;Leverageis
the ratioof total debt to total assets;Regulationis an indicatorvariablethatequals 1 for firmsin a regulated
industrywith two-digitSIC codes between40 and 49 or between60 and 63, and otherwise0; andAnalystsis
the numberof analystsprovidingannualearningsforecasts.
A key advantageof using consensus forecasts is that the aggregationprocess offsets

individualforecasterrors,or idiosyncraticerrors,which results in the consensus forecasts
being more accuratethan the individualforecasts (Brown et al. 1985). However,one con-
cern is that the idiosyncraticerrorsmay not be fully diversifiedaway when the consensus
is based on a few individualforecasts (Barronet al. 1998). Although any measurement
errorin the dependentvariabledoes not bias the estimatedcoefficients,the estimatedvar-
iances are largerand thereforethe t-statisticsare also lower (Gujarati1995). One solution
to the potential measurementerror problem is to impose a restrictionon the numberof
individualforecasts requiredto compute the mean forecast. The diversificationargument
suggests that the measurementerrordeclines with an increasein the numberof individual
forecasts.
Consistent with the diversificationargument,we find that the magnitude of the t-
statisticsbecomes largerwhen we impose restrictionson the numberof individualforecasts.
For instance, 33+ 34 is 0.01 and the associatedt-statisticis 2.90 in the second regression
(Table7). However,as in Barronet al. (2002), when we requirethatthe consensusforecasts
be based on a minimumof three individualforecasts, 33 + 34 is 0.01 but the t-statistic
increases to 3.40. The t-statisticjumps to 4.67 when the consensus forecast is based on a
minimumof seven individualforecasts.
Thus, our resultsfrom analystearningsforecastsare consistentwith the hypothesisthat
financialanalystsperceiveearningsquality as improvingwith longer auditortenure.
Sensitivity Analysis
We conducta numberof additionalanalysesto test the robustnessof our results.Instead
of tabulatingthe results of the additionaltests, we discuss them briefly in this subsection.
First, given that raw returnsare frequently used to estimate contemporaneousreturns-
earnings models (Lundholmand Myers 2002; Warfieldet al. 1995; Collins and Kothari
1989), we estimatethe returns-earnings regressionmodel using 12-monthcompoundedraw
returns(endingthreemonthsafterthe fiscal year-end)as the dependentvariable.The results
608 Ghosh and Moon
based on raw returnsare very similarto those reportedin Table3 using cumulativemarket-
adjustedreturns.The sum of the coefficients on E*Tenureand AE*Tenurefor the full and
restrictedsamples is 0.010 (t-statistic = 2.50) and 0.009 (t-statistic = 2.15), respectively.
The coefficient on Tenure is also positive and significant for the full sample (0.004,
t-statistic = 5.52) and the restrictedsample (0.003, t-statistic= 4.84).
Second, consideringthat cash flow might be an importantdeterminantof debt ratings,
we estimateDebt Ratingsregressionsafter includingoperatingcash flow (deflatedby mar-
ket value of equity at the beginningof the year) in additionto all the other variables.The
inclusionof the cash flow variabledoes not affect the tenorof the resultsreportedin Table
6. The coefficient on Tenurecontinues to be negative and significantfor the full sample
(-0.066, t-statistic = -4.91) and the restrictedsample (-0.067, t-statistic = -4.54). The
coefficient on cash flow is not significant.
Third, we also analyze S&P subordinateddebt ratings(Compustat#320). The sample
size is relatively small: the numberof observationsused in the yearly regressionsvaries
between251 and 372 for the full sampleand between245 and 358 for the restrictedsample.
The resultsfrom S&P subordinateddebt ratingsare very similarto those using seniordebt
ratings.The coefficient on Tenureis negative and significantfor the full sample (-0.047,
t-statistic = -2.96) and for the restrictedsample (-0.031, t-statistic = -1.89). The sum
of the coefficients on E*Tenureand AE*Tenureis negative but insignificant for both
samples.
Fourth,we estimate the effects of tenureon rankings/ratingsusing an orderedprobit
model. Since Stock Rankingsand Debt Ratings (the dependentvariables)are discrete out-
comes, conventionalregressionmethods could yield biased estimates (Greene 1993). We
find that the results in Tables 5 and 6 are not affected when we use an ordered probit
model. For example, the coefficient on Tenureis negative and highly significantfor the
StockRankingsregression(-0.036, x2 = 732.74) and the Debt ratingsregression(-0.039,
2 = 473.14) for the full sample.
Fifth, the results reportedin Table 7 are based on levels specification-earnings per
share forecasts(FEPS) and the two reportedearningsper sharemeasures(EPS and AEPS)
are not deflated.One concernis thatthe ordinaryleast squaresestimatesmightbe inefficient
and/or biased because of scale differences(Barthand Kallapur1996; Dechow 1994). Our
conclusions remainunchangedwhen we estimate the analyst forecast model after (1) de-
flating all the earningsper share variables(FEPS, EPS, and AEPS) by the stock price per
share at the beginningof the forecastperiod,and (2) deleting the top and bottom 1 percent
of the observationsfor each variable.The sum of the coefficients on EPS,_,*Tenureand
AEPS,_,*Tenureremains positive and significant for the full sample (0.015, t-statistic
= 3.05) and the restricted
sample (0.013, t-statistic= 2.08).
Finally, based on the specificationused in priorstudies,the analystforecastmodel does
not include earningspersistence.However,to maintainconsistency with the returns,stock
rankingsand debt ratings specifications,we also examine whether the analyst forecasts
results are robust to the inclusion of Persistence. When we include EPS,_~*Persistence,
AEPS,_,~*Persistence, and Persistence as additional independent variables, our conclusions
remain unaffected. The sum of the coefficients on and AEPS,_, *Tenure re-
EPSt,*Tenure
mainspositive and significantfor the full sample(0.017, t-statistic= 3.20) andthe restricted
=
sample (0.016, t-statistic 2.90).
VI. CONCLUSIONS
This study provides insights into the recent debate surroundingauditortenure, inde-
pendence,and auditquality by analyzingthe relationshipbetween auditortenureand audit
quality as perceivedby capital marketparticipants.We focus on a market-basedapproach

because academics,regulatoryinstitutions,and practitionersfrequentlyemphasizethe im-
portance of incorporatingcapital market perceptionsof independenceand audit quality
(Dopuch et al. 2003; Ryan et al. 2001; SEC 2000; Carmichael1999; AICPA 1994). Based
on the associationbetween perceivedreliabilityof financialstatementsand auditortenure,
we infer how capitalmarketsview tenureas affectingauditquality.All else equal, if capital
marketparticipantsperceive auditor tenure as improving (impairing)audit quality, then
reportedfinancialstatementsare viewed as more (less) reliable for investmentand credit
decisions.
We analyze the perceptionsof three primaryusers of audited financial statements:
investors,independentratingagencies, and financialanalysts.Using earningsresponseco-
efficients from returns-earningsregressionsas a proxy for investorperceptionsof earnings
quality (Schipperand Vincent 2003), we find evidence consistentwith the hypothesisthat
investorsperceive earningsquality as improvingwith auditortenure. Our analysis of the
perceptionsof independentratingagencies is based on how tenureaffects the association
between rankings/ratingsand reportedearnings. We find that the influence of reported
earningson stock rankingsbecomes largerwith extendedtenure,althoughthe influenceof
reportedearnings on debt ratings does not vary with tenure. Thus, our results provide
limitedevidence thatindependentratingagencies view auditortenureas having a favorable
impact on earningsquality. Finally, using earningscoefficients from a regressionof one-
year-aheadconsensus earningsforecastson reportedearningsas a proxy for analysts'per-
ceptions of earningsquality,we find evidence consistentwith the hypothesisthat financial
analystsperceive earningsquality as improvingwith extendedauditor-clientrelationships.
In general,most of our resultsare consistentwith the hypothesisthat auditedfinancial
statements,and in particularreportedearnings,are perceivedas more reliablefor firmswith
longer auditortenure.One implicationof our resultsis thatmanycapitalmarketparticipants
view longertenureas havinga favorableimpacton auditquality.Overall,our studysuggests
that imposing mandatorylimits on the durationof the auditor-clientrelationshipmight
impose unintendedcosts on capital marketparticipants.Our results are also subject to a
caveat.Resultsfrom a regime withoutauditortermlimits may not be applicableto a regime
with mandatoryauditorrotationbecause the incentivesfor auditorsand clients might differ
between the two regimes.
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