Azizkhani, Monroe & Shailer (2012)

Auditing: A Journal of Practice & Theory American Accounting Association
Vol. 32, No. 1 DOI: 10.2308/ajpt-50308

February 2013
pp. 183–202
Audit Partner Tenure and Cost of Equity

Capital
Masoud Azizkhani, Gary S. Monroe, and Greg Shailer
SUMMARY: We examine whether audit engagement partner tenure and rotation affect
investors’ perceptions, as proxied by the ex ante cost of equity capital. We find that
partner tenure has a nonlinear relation with the ex ante cost of equity capital for non-Big
4 audit engagements prior to the introduction of partner rotation requirements, and that
the imputed gains from partner tenure appear similar to the imputed gains of having a
Big 4 auditor. Consistent with the tenure results, we also find that partner rotation is
associated with increased ex ante cost of equity capital. Our results are very robust to a
variety of sensitivity tests and raise important questions for future research. It is not
known to what extent investors or analysts are aware of the audit partner’s identity or
pay attention to audit partner tenure; if investors or analysts do not consider partner
tenure, future research may identify omitted variables that have the same nonlinear
relationship with the ex ante cost of capital that we observe for non-Big 4 audit partner
tenure.
Keywords: audit partner tenure; audit partner rotation; financial reporting credibility;
cost of capital.
JEL Classifications: M42; M48.
Data Availability: The data used are from public sources identified in the manuscript.
Masoud Azizkhani is a Lecturer at The Australian National University and an Assistant Professor at Ilam
University, Gary S. Monroe is a Professor at The University of New South Wales, and Greg Shailer is an
Associate Professor at The Australian National University.
We are grateful to the anonymous referees and Robert Knechel for their constructive feedback on various versions of this
paper. We also thank Jean Bedard, Jeff Cohen, Neil Fargher, Dominic Gasbarro, Michael Martin, Ted Mock, Terry
O’Neil, Renee Radich, Roger Simnett, Philip Sinnadurai, Tom Smith, Stephen Taylor, Seng Teh, Farshid Vahid, Mark
Wilson, Sue Wright, the participants at the 2007 AAA Midyear Audit Conference, the 2007 International Symposium on
Audit Research, the 2007 Accounting and Finance Association of Australia and New Zealand Annual Conference, the
2006 Australian National Center for Audit and Assurance Research Symposium at Australian National University, and
seminar participants at The University of New South Wales and Macquarie University for their useful comments on
earlier drafts. We thank Elizabeth Carson at The University of New South Wales for her generous sharing of auditor
opinions data.
Editor’s note: Accepted by W. Robert Knechel.
Submitted: January 2010

Accepted: September 2012
Published Online: September 2012
183
184 Azizkhani, Monroe, and Shailer
INTRODUCTION
S
uccessive proposals by the PCAOB (2009, 2011) would require an audit firm to identify the
name of the engagement partner in the audit report. The proposals suggest that this provides
useful information to investors by allowing investors to identify audit partner tenure and
rotation. Professional accounting bodies and regulators have long been concerned that long
auditor-client relationships impair audit quality (e.g., AICPA 1978, 1992; ICAEW 2002; U.S.
House of Representatives [Sarbanes-Oxley Act] 2002; General Accounting Office 2003; CGAA
2003). However, the PCAOB noted that other commenters, generally accounting firms and
associations, do not believe disclosure of partner identity will provide meaningful information to
investors (PCAOB 2011). These opposing views are not well informed because of the limited
research available regarding audit partner tenure and rotation effects.1
This study investigates the usefulness of disclosing partner identity by exploring whether audit
partner tenure and partner rotation are informative to investors, as indicated by the ex ante cost of
equity capital. We focus on the cost of equity capital as an investor response because of its expected
association with the credibility of audited financial reports.2 We focus on audit partner tenure and
rotation because of the PCAOB proposal and because existing regulatory requirements regarding
auditor tenure and rotation, focus on the audit engagement partner rather than the audit firm. Boone
et al. (2008) examine the effect of audit firm tenure on the cost of equity capital, but the effect of
audit-engagement partner tenure on the cost of equity capital has not been investigated. Bamber and
Bamber (2009) argue against naively extrapolating the effects of audit firm tenure to audit partner
tenure because the costs and benefits of changes may be substantially different. We try to
disentangle the effects of audit partner tenure from audit firm tenure and audit firm switching
effects. By comparing partner and firm effects within our data set, we assess whether the observed
audit firm effects in the extant literature proxy for, dominate, or are incremental to partner effects.
We use Australian data because audit reports in Australia have identified audit engagement partners
for many years.3 The Australian setting is comparable to other developed Anglo-American
jurisdictions, such as the U.S. and U.K.4
We find that partner tenure has a nonlinear relation with the ex ante cost of capital for non-Big
4 engagements prior to the introduction of partner rotation requirements, and that partner rotation is
associated with increased ex ante cost of capital. We find the results are robust to a variety of
1
Bamber and Iyer (2007) report a significant association between individual auditor’s tenure and their
identification with their clients. Manry et al. (2008) find that audit quality ( proxied by discretionary accruals)
increases with audit partner tenure over seven years for smaller clients. Using Taiwanese data for audits prior to
the mandatory rotation of audit partners, Chi and Huang (2005) and Chen et al. (2008) find that audit quality
( proxied by abnormal accruals) increases with audit partner tenure. Using Australian data, Carey and Simnett
(2006) find that the probability of a going-concern qualification and just beating or missing earnings
benchmarks are negatively associated with partner tenure, but they do not find a significant relation between
partner tenure and abnormal accruals. Chi et al. (2009) report a positive association between audit quality and
audit partner rotation after rotation became mandatory in Taiwan. In Australia, Fargher et al. (2008) find
abnormal accruals tend to be smaller in years following partner rotation, while discretionary accruals are higher
following an audit firm switch.
2
We use the ex ante cost of equity capital because it has an expected association with the credibility of audited
financial reports, excludes the irrelevant time-series property of earnings effects, and provides a more direct
measure of information risk (Kothari 2001; Boone et al. 2008).
3
The Corporations Act 2001 (Cth), section 324(10) (Commonwealth of Australia 2001) requires the audit report
to be signed in both the audit firm’s and engagement partner’s names.
4
Audit reports also identify partners in Taiwan; Chi and Huang (2005) and Chen et al. (2008) find that audit
quality (abnormal discretionary accruals) increases with partner tenure. However, the Taiwan audit setting has
some problematic differences to many other countries. Taiwan has a dual signature requirement, but does not
distinguish who is the main audit partner, and the tenure of the two partners may differ. It is also suggests that
the enforcement of laws is weaker in Taiwan than in the U.S. or Australia (Chen at al. 2008).
Auditing: A Journal of Practice & Theory

February 2013
Audit Partner Tenure and Cost of Equity Capital 185
sensitivity tests, but it is not known to what extent investors or analysts are aware of the audit
partner’s identity or pay attention to audit partner tenure and we cannot rule out that some omitted
variable is driving our results. We discuss possible explanations for our results, but do not establish
causal effects, and we argue that further research is needed to explain the detected relations. Future
research could investigate whether analysts and investors are aware of and use partner identity and
tenure, or identify omitted variables that have the same nonlinear relationship with the ex ante cost
of capital that we observe for non-Big 4 audit partner tenure.
The remainder of this paper is organized as follows. We describe our research method and data
in the second section. Sample selection and descriptive statistics are in the third section. This is
followed by the presentation of our main results in the fourth section. Our discussion and additional
analyses are in the fifth section. In the sixth section, our conclusion emphasizes opportunities for
future research.
RESEARCH METHOD AND DATA

We examine the relation between client-specific ex ante cost of equity capital and audit partner
tenure using Model (1); and engagement partner rotation using Model (2):
Rp ¼ f ðPT; Big4; LEV; B=P; Beta; Growth; Size; VAR; ROA; Loss; GoingConcern;
QualifiedOther; EQ; Mills; Industry; YearÞ; ð1Þ
DRp ¼ f ðPR; AFT; AFS; Big4; DLEV; DB=P; DBeta; DGrowth; DSize; DVAR; DROA;
Loss; GoingConcern; QualifiedOther; Mills; Industry; YearÞ; ð2Þ
where:
Rp ¼ client-specific ex ante cost of equity capital estimated by the PEG model, expressed as a
percentage, estimated at first analyst forecast following release of the audited financial
statements;
PT ¼ engagement partner tenure (PT), measured as the number of consecutive years that the
audit report has been signed by the same audit partner;5
PR ¼ partner rotation, which is a dummy variable equal to 1 if the engagement partner changed
in year t without a change in audit firm, otherwise 0;
AFT ¼ audit firm tenure (AFT), measured as the number of consecutive years that the firm has
retained the audit firm;
AFS ¼ audit firm switch, which is a dummy variable equal to 1 if the audit firm changed in year
t, otherwise 0;
Big4 ¼ dummy variable equal to 1 if the audit firm is a Big 4 accounting firm in year t,
otherwise 0;6
LEV ¼ financial leverage measured by the ratio of total debt to total assets at the end of the
fiscal year;
B/P ¼ ratio of book value of equity to market value of equity at the end of the fiscal year;
Beta ¼ share beta (systematic risk) calculated over 28 months to the fiscal year-end;
5
Consistent with Johnson et al. (2002), we treat the auditor-client relationship as continuing when name changes
merely reflect mergers. During our study period, Price Waterhouse and Coopers & Lybrand merged, and most
Arthur Andersen partners joined Ernst & Young after the collapse of Arthur Andersen.
6
During the period covered by this study, mergers of accounting firms meant the Big N audit firms change from
the Big 6 to Big 4. For convenience, we refer to the Big 4 throughout this paper.

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Growth ¼ earnings growth measured as the difference between the mean analysts’ earnings
forecasts for four- and three-years ahead divided by the mean of three-years ahead
earnings forecasts;7
Size ¼ size measured by the natural logarithm of the market value of common equity at the end
of the fiscal year;
VAR ¼ earnings variability measured by the standard deviation of analysts’ earnings forecasts
available on I/B/E/S International during the fiscal year-end month;
ROA ¼ return on assets calculated as the ratio of earnings before interest and tax divided by
total assets;
Loss ¼ 1 if the firm reported a loss, otherwise 0;
GoingConcern ¼ 1 if the company received a going concern qualification in year t, otherwise 0;
QualifiedOther ¼ 1 if the company received a qualified audit report for a reason other than
going concern in year t, otherwise 0;
EQ ¼ earnings quality measured as the absolute value of residuals using the Dechow and
Dichev (2002) approach;
Mills ¼ inverse Mills ratio based on Heckman (1979) to control for Big 4 selection bias;
Industry ¼ dichotomous indicator variables based on two-digit SIC codes (24 industries) used
by the ASX;
Year ¼ dichotomous indicator variables to control for fiscal year; and
D ¼ change in the corresponding variable from year t1 to year t.
Ex Ante Cost of Capital

We estimate client-specific ex ante cost of equity capital using the price-earnings ratio divided
by the short-term earnings growth rate, which is the PEG model formulated by Easton (2004). This
measure dominates the alternative measures as a firm-specific estimate of ex ante cost of equity
capital (Botosan and Plumlee 2005).8 This is consistent with prior use of the PEG model to examine
the relation between the cost of equity capital and earnings attributes (Francis et al. 2004, 2005),
and to measure financial reporting credibility in relation to audit firm type (Khurana and Raman
2004; Azizkhani et al. 2010), auditors’ provision of non-audit services (Khurana and Raman 2006),
and audit firm tenure (Boone et al. 2008).9
Auditor Tenure
We test raw, log transform, and quadratic terms for auditor tenure. We find the quadratic terms
provide the best fitting models, and our reported results use the quadratic terms.10 We also interact
tenure with auditor type (Big 4 versus non-Big 4) because partner-tenure effects may be stronger
7
As part of our sensitivity tests, we examine whether the results are sensitive to short-term versus long-term
measures of growth. To test this, we also measure expected growth as the difference between the mean analysts’
earnings forecasts for three- and two-years ahead divided by the mean of two-year ahead earnings forecasts and
two- and one-years ahead divided by the mean of one-year ahead earnings forecasts. We also measure realized
growth as the difference between actual earnings per share for the current and previous year, divided by actual
earnings per share for the previous year. Our results are not affected by the alternative measures of growth.
8
Botosan and Plumlee (2005) compare different models for estimating ex ante cost of equity capital, and show
that the target price method and the PEG model dominate other alternatives in terms of providing estimates that
are correlated with all other risk factors (such as stock beta) in a consistent and theoretically expected direction.
9
Our approach does not imply analysts specifically incorporate partner identity or tenure into their forecasting
models. As discussed later, awareness of partner identity or tenure may influence the effective pricing of
forecasts by conditioning financial statement credibility.
10
The quadratic relation is consistent with recent evidence (Chi and Huang 2005; Boone et al. 2008; Davis et al.
2009).

February 2013
(weaker) for auditors from smaller (Big 4) firms because learning effects and the conjectured
economic dependence and reduced independence may be less for Big 4 auditors, who have more
resources and larger client bases.
Controlling for Big 4 Selection Bias

We use two-stage regressions (based on Heckman 1979) to address the potential for Big 4
selection bias (Raghunandan and Rama 1999; Johnstone 2000). Our first-stage uses the following
logistic regression model for auditor selection from Chaney et al. (2004):11
Big4 ¼ f ðTAssets; Aturn; DA; CA=TA; QR; ROA; LossÞ; ð3Þ
where:
TAssets ¼ the natural log of year-end total assets;
Aturn ¼ the natural log of asset turnover, calculated as sales divided by total assets;
DA ¼ the ratio of long-term debt to total assets;
CA/TA ¼ current assets divided by total assets; and
QR ¼ current assets minus inventory, divided by current liabilities.
ROA and Loss are as defined earlier. To conserve space, we do not report these first-stage results.12
Other Control Variables

Leverage (LEV) is prevalent in bankruptcy risk models and previous studies indicate that the
perceived risk associated with leverage is positively related to the cost of equity capital (e.g.,
Modigliani and Miller 1958; Fama and French 1992; Gebhardt et al. 2001). Prior research consistently
documents a positive relation between book-to-price ratios (B/P) and cost of equity capital as proxied
by average realized returns (e.g., Fama and French 1992; Khurana and Raman 2004; Boone et al.
2008). A firm’s cost of equity capital is positively associated with its systematic risk or Beta (Sharpe
1964; Botosan and Plumlee 2005). Earnings from growth opportunities (Growth) are riskier than
normal earnings, suggesting a positive relation between growth and equity risk (Beaver et al. 1970).
Consistent with prior empirical research (Berk 1995; Khurana and Raman 2004; Botosan and Plumlee
2005; Boone et al. 2008), we control for firm size, as measured by market capitalization. We include
VAR because Barth et al. (1999) report that stable and increasing earnings result in lower risk
premiums. We include ROA because reported earnings are expected to directly affect the cost of capital
through both investors’ expectations of returns (Gebhardt et al. 2001; Gode and Mohanram 2003) and
it has implications for the financial health of the firm, as signaled by its inclusion in bankruptcy risk
models. We use Loss and GoingConcern, in addition to LEV and ROA, as indicators of bankruptcy
risk. Earnings and leverage measures are long-established components in failure prediction models
(e.g., Altman 1968; Grice and Ingram 2001), and going concern qualifications in audit reports are a
direct warning of this risk. We control for audit qualifications that do not indicate going concern issues
in case these qualifications proxy for other omitted conditions. Francis et al. (2005) show that firms
with poor accrual quality have a higher cost of capital than firms with good accrual quality.13
11
Chaney et al. (2004) also include foreign sales as a percentage of total sales to control for the likelihood that
exporting firms are more likely to hire a Big 4 auditor. We do not include this variable because the data are not
available.
12
The auditor selection model is estimated using the sample of 2,499 firm-year observations, which includes firms
for which we are missing partner tenure and other data.
13
Guay et al. (1996) and Subramanyam (1996) also suggest a relation between earnings quality and cost of equity
capital.

February 2013
Following Francis et al. (2004), we utilize the Dechow and Dichev (2002) measure of earnings
quality.14 We control for the year and client-industry fixed effects. In Model (2) we control for audit
firm switches (AFS) to benchmark the relation between partner rotation and DRp.
SAMPLE SELECTION AND DESCRIPTIVE STATISTICS
Sample Selection and Data

Our sample is selected from all Australian-domiciled companies listed on the Australian Stock
Exchange during 1995–2005 that are included in the I/B/E/S International database. We exclude
cases that do not meet the PEG model constraint that eps2 . eps1 . 0 and that have extreme
estimates of Rp.15 We determined audit partner tenure and rotations, and firm tenure and switches,
by searching the published audit reports for engagement partners’ and audit firms’ names back to
the later of when the firm first listed or 1950 (the earliest year for which audit report data are
available). Data for the control variables were extracted from I/B/E/S International, Connect 4,
Australian Graduate School of Management Annual Reports Files, the CRIF database, and Aspect
Financial Analysis databases. We obtained 2,346 firm-year observations for which we can estimate
the ex ante cost of capital and identify audit firm and partner tenure. Missing control variables
reduce the sample size for PT to 1,828 for 1995–2005. The requirement of three years of cash flow
data to calculate EQ reduces the sample to 932 observations for 1996–2005; because of this large
reduction in sample size, we estimate Model (1) both with and without EQ. These sample sizes are
described, by year, in Panel A of Table 1.
Descriptive Statistics
Panel B of Table 1 reports summary statistics for our sample. Mean PT is 4.1 years, which breaks
down to 4.4 for 1995–2000, 3.7 for 2001–2002, and 3.3 for 2003–2005; Carey and Simnett (2006)
reported mean tenure of ‘‘just over 4 years’’ for listed Australian companies in 1995. Our sample of
1,828 observations includes 260 partner rotations (244 for Big 4 engagements). Our sample is
concentrated in the Top 300 and 88 percent are Big 4 engagements. Mean Rp, is 10.3 percent, the
same value reported by Khurana and Raman (2004) for their sample of Australian companies.
Table 2 reports the Pearson correlation matrix for the dependent and independent variables. The
correlation between AFS and Rp is positive. The negative correlation for PT with Rp is significant at
the 1 percent level. The Pearson correlation for the dichotomous PR with Rp is not significant. Both
AFT and AFS are significantly correlated with Rp. The significant correlations between Rp and the
control variables are all in the expected direction; only QualifiedOther is not significant.
RESULTS
In this section, we report and only briefly discuss the main results. A more substantial
discussion and further testing are presented in the next section. We estimate all of our tenure models
using OLS with robust standard errors clustered by company to alleviate serial correlation and
heteroscedasticity issues arising from pooled data (Rogers 1993).
14
We estimate EQ for each combination of industry sector (four-digit GICS) and year, using all listed Australian
companies, excluding financial institutions, with data available on the Aspect Financial Database (10,085 firm-
year observations).
15
Examining the means of audit-firm partner tenure, audit firm tenure, and company size of observations that are
excluded from the sample, reveals no significant differences with the means of the final sample. The means of
AFT and PT for excluded observations are 9.1 and 3.9 years, respectively.

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TABLE 1
Descriptive Statistics
Panel A: Partner Tenure Sample Size by Year

Sample Criteria 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Total
Full PT sample before 166 177 201 198 213 234 252 241 227 227 210 2,346
missing data
PT sample without EQ, 124 151 167 123 168 172 185 204 193 184 157 1,828
with Mills
With EQ — 50 67 52 73 81 101 129 136 131 112 932
Panel B: Descriptive Statistics for the Pooled Sample

Mean or Std.
Variable n Percentage Median Dev.
Rp (%) 1,828 10.27 9.18 5.41
PT (Years) 1,828 4.09 3 3.21
AFT (Years) 1,828 8.99 7 7.71
LEV 1,828 0.47 0.49 0.17
B/P 1,828 0.66 0.57 0.55
Beta 1,828 1.06 0.94 0.76
Growth 1,828 0.17 0.08 2.64
Size (Ln) 1,828 20.17 20.07 1.50
VAR 1,828 0.02 0.01 0.03
ROA 1,828 0.07 0.07 0.08
EQ 932 0.10 0.04 0.32
Loss 1,828 4.8%
GoingConcern 1,828 0.3%
QualifiedOther 1,828 0.4%
Big4 1,828 88.3%
PR 1,828 14.2%
AFS 1,827 4.7%
The percentage of partner rotation and audit firm switches are calculated as the number of rotations or switches divided
by n.
(continued on next page)
Results for Partner Tenure

The results for Model (1) are reported in Table 3.16 We first estimate Model (1) without EQ
(column 1), then with EQ (column 2), as a check against missing data bias. Most control variables
are significant in the expected direction and consistent with prior studies (e.g., Gebhardt et al. 2001;
Gode and Mohanram 2003; Francis et al. 2004, 2005; Khurana and Raman 2004, 2006; Boone et al.
16
We also use the median of analysts’ earnings forecasts, in place of mean forecasts, to estimate ex ante cost of
equity capital and obtain results that are the same as those reported for our main analyses. Because measurement
error can arise with small numbers of analyst forecasts (see Barron et al. 1998), we also re-estimate our models
using samples variously restricted to firms followed by at least two, three, five, and seven financial analysts, as in
Chung et al. (1995) and Ghosh and Moon (2005). In these re-estimations, the results for our test variables are
consistent with, and sometimes stronger than, those reported for our main analyses.

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TABLE 1 (continued)
Variable Definitions:
Rp ¼ client-specific ex ante cost of equity capital estimated by the PEG model;
PT ¼ engagement partner tenure;
AFT ¼ audit firm tenure;
LEV ¼ ratio of total debt to total assets;
Size ¼ market value of common equity at the end of fiscal year. The raw value of Size is shown for descriptive purposes
only. Its logarithmic form is used in the regression model;
B/P ¼ ratio of the book value of equity to market value of equity at the end of fiscal year;
Beta ¼ (systematic risk) is calculated over 28 months ending the fiscal-year end;
VAR ¼ earnings variability measured by the dispersion in analysts’ earnings forecasts;
Growth ¼ difference between the mean analysts’ earnings forecasts for four- and three- years ahead divided by the mean
of three-year ahead earnings forecasts;
ROA ¼ return on assets calculated as the ratio of earnings before interest and tax divided by total assets;
EQ ¼ lagged unsigned earnings quality measured using the Dechow and Dichev (2002) approach;
Loss ¼ 1 if the firm reported a loss, 0 otherwise;
GoingConcern ¼ 1 if the company received a going concern qualification in year t, 0 otherwise;
QualifiedOther ¼ 1 if the company received a qualified audit, 0 otherwise;
Big4 ¼ 1 if the firm is audited by a Big4 auditor, 0 otherwise;
PR ¼ 1 if the engagement partner changed in year t without a change in audit firm, 0 otherwise; and
AFS ¼ 1 if the client switched audit firms in year t, 0 otherwise.
2008). Generally, Rp is positively related to LEV, B/P, Beta, Loss, and GoingConcern, and
negatively related to Size and ROA. When we include EQ in the second regression, Growth and
VAR are not significant. Although there is a substantial reduction in sample size with the inclusion
of EQ, all of our test variables remain significant.17 The coefficient for the main effect of Big4 is
significantly negative in all of our regressions, supporting the proposition that the market associates
Big 4 audit firms with higher quality audits.18
PT is significantly negative and PTSQ is significantly positive, consistent with the U-shape
reported for U.S. audit firm tenure in Boone et al. (2008) and Davis et al. (2009). The significant
interactions between partner tenure and Big 4 indicate that the effect of partner tenure applies only
to non-Big4 engagements.19
It can be argued that partner tenure might merely proxy firm tenure. This potential substitution
effect is not adequately clarified when we replace the partner tenure terms with firm tenure terms
(column 3), because we obtain seemingly weaker but very similar results. The issue then arises as to
how to disentangle partner-tenure and firm-tenure effects. One approach is to include and interact
17
Cases for 1995 are omitted from our sample when we include lagged EQ. To ensure that inclusion/exclusion of
1995 cases does not influence our results, we re-estimated the first regression (i.e., without EQ) omitting 1995
cases. The results are substantially the same as the reported model, with the coefficients for the test variables
identical to the first decimal place.
18
Our finding of a significant association between Big4 and the ex ante cost of capital contradicts the Australian
result reported in Khurana and Raman (2004). Khurana and Raman (2004) used the intersection of the I/B/E/S
International, the Global Vantage Industrial Commercial File, and Issue Files for 1990–1999 to select their
Australian sample, biasing their sample toward larger companies. Their sample sizes for 1995–1999 range from
63 to 108 companies per year. We also use I/B/E/S International, but we extract our accounting information from
the Connect 4 and Aspect Financial databases, resulting in less bias towards large companies. Our sample size
for 1995–1999 ranges from 129 to 189 companies per year. We obtain the same result as Khurana and Raman
(2004) for Big 4 audit firms if we restrict our sample to the largest 100 firms for the period 1995 to 1999.
19
Summing the coefficients for PT þ PT 3 Big4 and PTSQ þ PTSQ 3 Big4, we obtain Big4 coefficients of 0.0645
for PT and 0.0083 for PTSQ in the first regression (without EQ), and 0.1525 for PT and 0.0137 for PTSQ in
the second regression (with EQ); none of these are statistically significant. The coefficients for PT and PTSQ in
column (2) yield a turning point of 7.9 years for non-Big 4 partner tenure.

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TABLE 2
Pearson Correlation Matrix
Panel A: Variables RP to B/P
Rp PT PR Big4 AFT AFS LEV B/P
PT 0.061
0.009
PR 0.031 0.391
0.133 , 0.001
Big4 0.050 0.123 0.074
0.031 , 0.001 0.002
AFT 0.045 0.332 0.070 0.120
0.054 , 0.001 0.003 , 0.001
AFS 0.050 0.214 0.090 0.032 0.230
0.034 , 0.001 , 0.001 0.166 , 0.001
LEV 0.077 0.017 0.004 0.098 0.053 0.020
0.001 0.473 0.873 , 0.001 0.023 0.391
B/P 0.198 0.006 0.002 0.033 0.013 0.036 0.026
0.000 0.790 0.931 0.164 0.577 0.129 0.273
Beta 0.237 0.024 0.013 0.037 0.095 0.066 0.045 0.058
0.000 0.312 0.586 0.117 , 0.001 0.005 0.057 0.013
Growth 0.035 0.032 0.017 0.044 0.007 0.024 0.003 0.033
0.040 0.177 0.463 0.058 0.759 0.311 0.916 0.165
Size 0.357 0.069 0.027 0.215 0.216 0.037 0.076 0.246
0.000 0.003 0.255 , 0.001 , 0.001 0.119 0.001 0.000
VAR 0.148 0.086 0.049 0.052 0.133 0.025 0.106 0.022
0.000 0.002 0.037 0.025 , 0.001 0.286 , 0.001 0.342
ROA 0.255 0.007 , 0.001 0.057 0.039 0.023 0.027 0.016
0.000 0.756 0.990 0.014 0.095 0.333 0.252 0.490
Loss 0.383 0.023 0.002 0.023 0.059 0.035 0.048 0.083
0.000 0.324 0.918 0.327 0.012 0.132 0.040 , 0.001
GoingConcern 0.182 0.001 0.009 0.019 0.027 0.012 0.139 0.270
0.000 0.950 0.708 0.416 0.247 0.619 , 0.001 , 0.001
QualifiedOther 0.023 0.013 0.025 0.005 0.028 0.014 0.014 0.008
0.336 0.585 0.282 0.828 0.237 0.556 0.554 0.997
EQ 0.091 0.064 0.033 0.040 0.031 , 0.000 0.065 , 0.001
0.002 0.032 0.263 0.178 0.297 0.999 0.029 0.997
partner tenure and firm tenure (with Big4) in the model. However, for the sample used to estimate
these models (n ¼ 932), 42 percent of the sample has PT ¼ AFT (n ¼ 394), and 58 percent has PT ,
AFT (n ¼ 538). Therefore, in this sample, AFT determines the boundaries within which PT varies,
and the terms are co-linear with a correlation of 0.33. Consequently, this approach is problematic,
resulting in high multicollinearity. To address this issue, we create a new variable AFTPRIOR ¼ AFT
PT, which indicates the amount of firm tenure prior to the last partner rotation. This avoids
multicollinearity arising from partner and firm tenure, with the correlation between PT and
AFTPRIOR ¼ 0.10. To further consider the relation between partner and firm tenure, we estimate the
model separately for subsamples PT ¼ AFT and PT , AFT. For PT ¼ AFT, the maximum auditor
tenure is 15 years. For PT , AFT, maximum PT is 18 years and maximum AFT is 40 years (all

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TABLE 2 (continued)
Panel B: Variables Beta to QualifiedOther

Going Qualified
Beta Growth Size VAR ROA Loss Concern Other
Growth 0.007
0.781
Size 0.042 0.003
0.073 0.893
VAR 0.049 0.031 0.145
0.038 0.190 , 0.001
ROA 0.041 0.016 0.012 0.091
0.081 0.494 0.624 , 0.001
Loss 0.149 0.007 0.178 0.128 0.474
, 0.001 0.755 , 0.001 , 0.001 , 0.001
GoingConcern 0.048 0.009 0.069 0.082 0.048 0.185
0.042 0.708 0.003 , 0.001 0.041 , 0.001
QualifiedOther 0.005 0.002 0.055 0.005 0.015 0.028 0.003
0.818 0.939 0.020 0.829 0.551 0.236 0.890
EQ 0.001 0.038 0.107 0.004 0.111 0.016 0.001 0.010
0.978 0.198 , 0.000 0.887 , 0.001 0.606 0.970 0.731
p-values are italicized. Correlations are based on available firm-year observations over 1995–2004.
Rp ¼ ex ante cost of equity capital (%) estimated by the PEG model;
Big4 ¼ 1 if the firm is audited by a Big 4 auditor, 0 otherwise;
B/P ¼ ratio of the book value of equity to market value of equity at the end of fiscal year;
Size ¼ natural logarithm of the market value of common equity at the end of the fiscal year;
PR ¼ 1 if the engagement partner changed in year t without a change in audit firm, 0 otherwise;
AFS ¼ 1 if the client switched audit firms in year t, 0 otherwise;
QualifiedOther ¼ 1 if the company received a qualified audit, 0 otherwise; and
EQ ¼ lagged unsigned earnings quality measured using the Dechow and Dichev (2002) approach.
cases of AFT 20 years are Big 4 engagements).20 The split-sample results are reported as columns
(4) and (5) in Panel B of Table 3. To conserve space, we do not report the control variables for the
models in Panel B, which are consistent with the previous estimations. The results for the split-
sample estimations are consistent with those for the combined sample. For the subsample where PT
20
In the larger sample obtained by excluding EQ (n ¼ 1,828), we have 18 firm-year observations (six engagements)
for PT . AFT; these are all Big 4 engagements. This larger sample has only six observations (three engagements)
where PT . 18 years; two (four) of these observations are Big 4 (non-Big 4). Consequently, we do not anticipate
that the missing observations caused by the estimation of EQ particularly bias our estimations, but we do not
have sufficient cases where PT . AFT for analysis.

February 2013
TABLE 3
Regressions of ex ante Cost of Equity Capital (Rp) on Partner Tenure (Model 1)
Panel A: Main Results

(1) (2) (3)
PT without EQ PT with EQ AFT with EQ
Variable Pred. b p-valuea b p-valuea b p-valuea
PT 0.45 0.002 1.35 0.001 — —
PTSQ þ 0.01 0.009 0.09 0.001 — —
PT 3 Big4 þ 0.53 0.002 1.45 , 0.001 — —
PTSQ 3 Big4 0.02 0.001 0.10 , 0.001 — —
AFT — — — — 1.07 0.002
AFTSQ þ — — — — 0.05 0.005
AFT 3 Big4 þ — — — — 1.09 0.002
AFTSQ 3 Big4 — — — — 0.05 0.005
Big4 2.10 0.010 3.77 0.005 4.20 0.004
LEV þ 3.15 , 0.001 2.23 0.058 2.32 0.057
B/P þ 1.27 0.001 1.45 0.020 1.32 0.022
Beta þ 0.91 , 0.001 0.53 0.005 0.47 0.011
Growth þ 0.05 0.111 0.05 0.447 0.04 0.551
Size 0.86 , 0.001 0.62 0.042 0.75 0.018
VAR þ 17.67 0.008 1.56 0.760 4.32 0.278
ROA 14.31 , 0.001 19.46 , 0.001 17.79 , 0.001
Loss þ 3.70 , 0.001 3.85 , 0.001 4.69 , 0.001
GoingConcern þ 6.97 0.085 27.29 , 0.001 25.78 , 0.001
QualifiedOther ? 2.59 0.059 3.46 0.010 3.57 0.010
Mills ? 3.37 0.167 6.01 0.092 4.87 0.176
EQ þ — — 0.55 0.167 0.57 0.138
R2 0.41 0.47 0.46
Adjusted R2 0.39 0.44 0.43
n 1828 932 932
¼ AFT, there has been no partner rotation on the engagement and AFTPRIOR ¼ 0 in all cases; while
PT ¼ AFT in this subsample, we report tenure in column (4) as PT. The turning point (maximum
gain) for non-Big 4 partner tenure is 8.3 years, with the corresponding decrease in Rp, at that point,
being 8.5 percent, compared to the constant decrease for Big4 engagements of 6.3 percent. For PT
, AFT (column 5), the terms for prior audit-firm tenure are not significant and the turning point for
non-Big 4 partner tenure is 6.3 years, with the decrease in Rp, at that point, being 7.6 percent,
compared to the constant decrease of 5.1 percent for Big4.21 However, the results in column (5) are
21
We also re-estimate Model (1): (1) adding an indicator variable equal to 1 for cases where PT ¼ AFT; and (2)
interacting the PT ¼ AFT indicator with PT and PTSQ. In both extensions, the added variables are not significant
and the coefficients for PT and PTSQ are substantially the same as those reported for each of the regressions in
Table 3. We also test various transformations of AFTPRIOR and obtain consistent results for partner tenure and no
significance for prior firm tenure.

February 2013
TABLE 3 (continued)
Panel B: Additional Tests on Partner and Firm Tenure

(4) (5) (6)
PT ¼ AFT PT , AFT PT with AFTPRIOR 3 NRb
Variable Pred. b p-valuea b p-valuea b p-valuea
PT 2.06 0.006 2.40 0.006 2.44 0.005
PTSQ þ 0.12 0.004 0.19 0.004 0.18 0.008
PT 3 Big4 þ 2.10 0.005 2.40 0.005 2.46 0.005
PTSQ 3 Big4 0.13 0.003 0.20 0.003 0.19 0.007
AFTPRIOR — — 1.06 0.260 1.43 0.140
AFTPRIORSQ þ — — 0.14 0.260 0.17 0.175
AFTPRIOR 3 Big4 þ — — 1.08 0.256 1.47 0.135
AFTPRIORSQ 3 Big4 — — 0.14 0.260 0.17 0.175
Big4 6.32 0.006 5.09 0.005 6.07 0.002
Other control variables included included included
R2 0.60 0.39 0.46
Adjusted R2 0.56 0.34 0.43
n 394 538 932
a
p-values are one-tailed when the sign of the coefficient is in the predicted direction, otherwise they are two-tailed; p-
values are based on robust standard errors clustered on firm.
b
NR is a categorical variable ¼ 1 if PT ¼ AFT. NR and the interaction terms for NR and all test variables are not
significant and are omitted from the table.
All models include fixed effects for industry and year.
Rp ¼ ex ante cost of equity capital (%) estimated by the PEG model;
PT 3 Big4 ¼ interaction term between PT and Big4;
AFT 3 Big4 ¼ interaction term between AFT and Big4;
Big4 ¼ 1 if the firm is audited by a Big 4 auditor, 0 otherwise;
B/P ¼ ratio of the book value of equity to market value of equity at the end of the fiscal year;
Size ¼ natural logarithm of the market value of common equity at the end of the fiscal year;
QualifiedOther ¼ 1 if the company received a qualified audit, 0 otherwise; and
EQ ¼ lagged unsigned earnings quality measured using the Dechow and Dichev (2002) approach.
conditioned by the fact that there has been a prior partner rotation, creating ambiguity as to the
incremental effects of prior firm tenure in relation to partner tenure.
To address this conditional effect interpretation issue, we estimate a joint PT and AFTPRIOR
model; the results of the main test variables are reported in column (6) in Panel B of Table 3. In this
model, we created an indicator variable (NR) to distinguish cases where PT ¼ AFT from PT , AFT;
NR ¼ 1 if PT ¼ AFT. In addition to the interaction terms reported in column (6), we interacted NR
with all of those terms and the main effects; none of these NR terms are significant and, to conserve

February 2013
space, they are not tabulated. The results are consistent with the split-sample results. Nonlinear
partner tenure remains significant and prior firm tenure is not significant.22
While we cannot fully separate the potential commonality of partner-tenure and firm-tenure
effects, the results across Table 3 suggest that partner tenure is driving the results.23
Sub-Period Analysis
We examine whether audit partner-tenure effects were affected by the financial scandals and
public debates from 2003 regarding auditor independence and the subsequent introduction of
professional requirements for audit partner rotation.24 These events resulted in considerable public
exposure of the issues of auditor independence and the credibility of financial reporting. Such a
high level of public exposure may have impacted on perceptions that relate audit attributes to audit
quality and, therefore, auditors’ capacity to reduce information risk.25 We partition our sample into
the sub-periods 1996–2002 and 2003–2005 and re-estimate the regressions for Model (1) reported
in columns (2) and (3) in Table 3. To conserve space, the results are not tabulated, but the quadratic
relation for non-Big 4 partner tenure and the Big 4 fixed effect hold for 1996–2002 but neither the
relation between PT and Rp nor the Big4 effect are significant at conventional levels for 2003–2005.
The non-significance of PT post-2002 is consistent with the post-SOX effects for firm tenure
reported in Davis et al. (2009). In our case, the post-2002 results may be a consequence of the
partner-rotation requirements effective from 2003. In our sample, PT is greater than seven years for
16.1 percent of our observations for 1996–2002, but for only 6.6 percent for 2003–2005, and the
sub-period sample means (range) of PT for 1996–2002 and 2003–2005 are 4.4 (29) and 3.4 (14)
years, respectively; this contrasts with a minor change in mean AFT from 9.0 for 1996–2002 to 8.9
for 2003–2005. The substantially reduced variation in PT for 2003–2005 may be sufficient to
preclude statistical detection of any tenure effect in our sample. Nonetheless, we do not discount the
possibility that the 2003–2005 period was still in flux with respect to perceptions of the credibility
of audits, and that partner-tenure and Big 4 effects may re-emerge in later years.
Results for Partner Rotation

We use Model (2) to examine whether audit partner rotations are related to changes in Rp. The
data requirements to measure changes reduce the sample to 1,181 cases, including 183 partner
rotations and 67 audit firm switches. As reported in Table 4, the association between DRp and PR is
significant and positive. This does not appear to be limited to non-Big 4 engagements, as PR 3 Big4
and Big4 are not significant. Neither non-directional nor directional firm switches (AFS or NonBig4-
Big4 and Big4-Big4) are significant, indicating that audit firm switches are not comparable to
22
We also re-estimate the model after adding interactions between PT and PTSQ with AFTPRIOR and AFTPRIORSQ,
and with other and NR and Big4. All of these interaction terms were not significant, the reported AFTPRIOR terms
remained non-significant, and our PT terms remained significant. We therefore exclude these complex
interactions from further analyses.
23
In all cases in our test sample, audit partner tenure is within the bounds of audit firm tenure. Consequently, we
cannot completely separate the effects of audit partner tenure from audit firm tenure.
24
Alongside the policy debate regarding auditor rotation during 2001–2002, with frequent reference to U.S.
developments, Australia’s professional accounting bodies amended their independence standard Professional
Statement F1, Professional Independence F1, to require rotation of the lead partner within seven years, effective
from 2003, similar to the previous U.S. requirement. Prior to 2003, audit partner rotation in Australia was
voluntary.
25
The argument that a high level of public exposure may have impacted on perceptions of the relation between
audit attributes and audit quality is more likely for our sample because the Royal Commission Report on the
collapse of HIH in Australia identifies the length of the relationship between HIH and Andersen (HIH’s auditor)
as one of the possible reasons for this scandal (HIH Royal Commission 2003, Sec 7.2.1).

February 2013
TABLE 4
Regression of Changes in Ex Ante Cost of Equity Capital (DRp) on Partner Rotation
Variable Predicted b p-valuea
PR ? 1.72 0.043
PR 3 AFT ? 0.24 0.136
PR 3 AFTSQ ? 0.01 0.270
Big4 1.43 0.095
AFT 0.44 0.022
AFTSQ þ 0.03 , 0.001
Big4 3 AFT þ 0.47 0.022
Big4 3 AFTSQ 0.03 , 0.001
Big4-Big4 ? 0.69 0.398
NonBig4-Big4 ? 0.91 0.510
DLEV þ 2.52 0.076
DB/P þ 2.42 , 0.001
DBeta þ 0.10 0.325
DGrowth þ 0.05 0.347
DSize 1.28e10 0.046
DVAR þ 12.94 0.103
DROA 16.74 , 0.001
Loss þ 1.40 0.422
GoingConcern þ 7.57 0.050
QualifiedOther ? 11.91 , 0.001
Mills ? 0.21 0.849
Constant 1.21 0.303
Industry fixed effects included
Year fixed effects included
R2 0.24
Adjusted R2 0.21
n 1,181
a
p values are one-tailed when the sign of the coefficient is in the predicted direction, otherwise they are two-tailed.
To conserve space, the coefficients for industry fixed effects and year fixed effects are not reported.
DRp ¼ change in the ex ante cost of equity capital estimate by the PEG model measured as the difference between yeart1
to yeart;
PR ¼ 1 if the engagement partner changed in year t without a change in audit firm, otherwise 0;
AFS ¼ dummy variable equal to 1 if the audit firm changed in year t, otherwise 0;
Big4-Big4, NonBig4-Big4 ¼ 1 if the client switched from a (non)Big 4 auditor to a Big 4 auditor as indicated, otherwise
0;
DLEV ¼ changes in financial leverage from yeart1 to yeart;
DB/P ¼ changes in the ratio of the book value of equity to market value of equity at the end of the fiscal year from yeart1
to yeart;
DBeta ¼ (systematic risk) the changes in market beta from yeart1 to yeart;
DGrowth ¼ changes in earnings growth from yeart1 to yeart;
DSize ¼ changes in natural logarithm of the market value of common equity at the end of the fiscal year from yeart1 to
yeart;
DVAR ¼ changes in earnings variability from yeart1 to yeart;
DROA ¼ change in return on assets calculated as the ratio of earnings before interest and tax divided by total assets from
yeart1 to yeart;
Loss ¼ 1 if the firm reported a loss, otherwise 0;
GoingConcern ¼ 1 if the company received a going concern qualification in year t, otherwise 0; and
QualifiedOther ¼ 1 if the company received a qualified audit opinion, otherwise 0.

February 2013
partner rotations with respect to DRp.26 The control variables are generally consistent with our
results for the partner tenure. The expertise hypothesis suggests that, the longer the firm tenure, the
more client-specific knowledge is accumulated within the firm and available to the incoming
partner, potentially reducing the loss of expertise associated with partner rotation. We model this
using the nonlinear firm tenure relation; the main effects for AFT and AFTSQ are not significant.
The quadratic relation is not significant at conventional levels.
FURTHER TESTING OF THE BIG 4/NON-BIG 4 EFFECTS

In this section, we examine two possible explanations for the auditor tenure and Big 4/non-Big
4 effects we observed in our main results. We investigate whether the effects are: (1) a consequence
of increased auditor visibility, or (2) merely proxying a tenure-earnings quality relation.
Auditor Visibility
The relation between auditor tenure and the ex ante cost of capital may be limited to conditions
that encourage investors to pay more attention to audit partner tenure. For example, investors and
analysts may pay attention to partner identity and tenure when a large listed company chooses a
non-Big 4 auditor because this is an unusual choice as most large listed companies choose Big 4
auditors. To test whether the relation between audit partner tenure and the cost of equity capital is a
consequence of increased auditor visibility, we first use split-sample tests to assess whether our
results hold for different ranges of selected potential visibility indicators. These include client
ownership, industry, size, risk, profitability, and difficulties in estimating earnings. These factors
may cause investors to consider the implications of non-Big 4 auditor choices, or they may produce
the appearance of differences in non-Big 4/Big 4 tenure effects if these circumstances are associated
with the choice of auditor type. We also test for industry effects, ownership characteristics, and firm
age.27
We first re-estimate our tenure model using split-samples based on median splits of client size
(SIZE), profitability (ROA), leverage (LEV), and difficulty in predicting earnings (VAR). Within
each subsample, based on the median splits for SIZE, ROA, LEV, and VAR, the magnitudes of
coefficients vary but we consistently find a significant nonlinear partner-tenure relation for non-Big
4 engagements and not for Big 4 engagements. Reported losses may also increase visibility, but
only 4 percent of our sample reports a loss. We estimate the model excluding cases where the
company reported a loss, and obtain results consistent with those reported for the full sample,
indicating differences between loss firms and non-loss firms do not drive our results.
In relation to industry effects, financial institutions have risk and complexity characteristics that
are different from those of other firms (Fields et al. 2004) and their financial measures, such as
leverage, are different from those of nonfinancial firms. Re-estimating Model (1), after excluding
financial firms (36 observations), yields the same quadratic partner-tenure relation reported for the
main model, with only minor changes in the coefficients for some control variables. We also
estimate the model after limiting the sample to those industries where we have cases of both Big 4
and non-Big 4 auditors (this excludes 183 observations), and obtain results consistent with those
reported for the full sample. Studies using Australian data frequently control for the mining industry
to make sure results are not driven by this particular industry. We control for fixed effects using
26
We control for 46 switches from Big 4 to Big 4 audit firms and 17 from non-Big 4 to Big 4 audit firms. We do not
control for the three switches from non-Big 4 auditors to non-Big 4 auditors (their inclusion does not affect the
results). There are no switches from Big 4 to non-Big 4 auditors.
27
The small numbers of non-Big 4 auditors constrain our split-sample testing.

February 2013
industry indicator variables in our reported results. We also estimate our models excluding mining
companies and obtain the same results.
Prior research reports that shareholder concentration affects a firm’s agency costs and, thereby,
a firm’s cost of capital (Jensen 1993; Bhide 1993; Shleifer and Vishny 1997). Therefore, we include
the percentage of shares held by the top 20 shareholders in Model (1). This variable is significantly
positive (p ¼ 0.088, two-tailed; n ¼ 880), but we obtain the same results for partner tenure. We also
estimate the model using a split-sample (above and below median of the percentage of shares held
by the top 20 shareholders, and obtain the same nonlinear relations for both subsamples. When we
add either the number of blockholders (shareholders with more than 5 percent equity ownership) or
the percentage of shares held by blockholders to Model (1), they are not significant and do not
affect the results for our test variables.
Auditor tenure may proxy the number of years the client has been operating because tenure and
company age (years listed) are highly correlated (55 percent) and older companies may be
perceived by financial analysts as more mature and stable, and, therefore, less risky.28 In our
sample, mean company age is significantly larger for Big 4 compared to non-Big 4 (17.3 years
compared to 10.5 years), so we interact company age with Big4. We find that company age is
significantly negative (p ¼ 0.063, one-tailed) for non-Big 4 only, and we still obtain the quadratic
partner-tenure relation for non-Big 4.
While we obtain differences in coefficients for some control variables in some of our auditor
visibility tests, we obtain a significant quadratic relation between audit partner tenure and the cost of
equity capital for non-Big 4 engagements in all cases.
Discretionary Accruals
Using Australian audit partner data, Fargher et al. (2008) find discretionary accruals tend to be
smaller in years following partner rotation, but Carey and Simnett (2006) do not find a significant
relation between partner tenure and discretionary accruals. Francis et al. (2005) show that firms with
poor accrual quality have a higher cost of capital than do firms with good accrual quality. However,
the discretionary accruals control variable (EQ) in our main analyses is not significant. Nonetheless,
as reported in Table 2, EQ and PT are significantly correlated in our sample, and, therefore, it is
possible that it is really an earnings quality effect that is driving our estimated partner-tenure relation.
This may arise if partner tenure has a quadratic relation with discretionary accruals and this relation
exists only for non-Big 4 auditors; Manry et al. (2008) find that discretionary accruals increase for
longer audit partner tenure (over seven years) for smaller clients. We first test whether our results are
merely proxying a tenure-earnings quality relation by replacing the ex ante cost of equity capital with
EQ as the dependent variable in Model (1). We also estimate the model reported in Chi and Huang
(2005), both with and without interactions between auditor type and tenure, and using signed and
unsigned discretionary accruals. To conserve space, we do not tabulate these various regressions. We
do not obtain a significant quadratic relation between partner tenure and EQ in either test. Therefore,
we conclude that it is unlikely that the quadratic relation we observe between non-Big 4 partner
tenure and ex ante cost of equity capital is proxying for a tenure-earnings quality relation.
LIMITATIONS AND FURTHER RESEARCH

Prior research suggests that the length of auditor-client relationship affects audit quality, and,
therefore, the integrity and information risk associated with a client’s financial reporting. We
28
Company age is correlated with Big 4. Therefore, a median split on company age results in very few cases of
non-Big 4 in the subsample of older firms.

February 2013
identify a significant quadratic relation between audit partner tenure and the ex ante cost of equity
capital for non-Big 4 audit firms, and a significant increase in the cost of equity capital following
partner rotation. The decline we observe in partner-tenure effects post-2002 suggests that market
participants may be less inclined to regard auditor tenure as a significant issue following the
introduction of compulsory audit partner rotation—but further research over a longer
post-mandatory rotation period is needed to adequately assess any trend in this regard.
Our sample is biased toward larger, more stable and less risky firms with analyst followings.
This arises from measuring the cost of equity capital with the PEG model, which requires positive
and increasing earnings forecasts by analysts. We cannot implement methods to adjust for the
positive growth sample bias, such as the target price method (Botosan and Plumlee 2002), because
of the absence of the necessary data for Australian companies. It is not obvious that this influences
our results, but our modeling and sampling may prevent the identification of an existing
partner-tenure effect for Big 4 engagements. It may also diminish the effectiveness of our further
testing for auditor visibility. To better address this concern, future research might explore these
relations using other cost of equity measures (e.g., Claus and Thomas 2001; Gebhardt et al. 2001;
Easton 2004).
Because partner tenure is strongly significant but moderated by firm tenure, while firm tenure
as a main effect is not significant, our results suggest partner tenure dominates firm tenure in users’
perceptions of audit quality or reporting credibility, to the extent that they are reflected in the ex
ante cost of equity capital. A possible avenue of investigation to further disentangle firm and
partner-tenure effects is to use a matched pairs design for firms of equal firm tenure but different
partner tenure. However, sample size issues currently impede this. Also, we are wary of suggesting
that the prior firm-tenure effects observed in studies of comparable jurisdictions may actually proxy
partner-tenure effects because partner identity is not as readily observable in comparable
jurisdictions. Consequently, this remains an issue for further investigation.
Overall, our results present some interesting challenges to be addressed by future research. The
finding that partner tenure is significantly associated with the ex ante cost of capital for non-Big 4
engagements, at least prior to the introduction of mandated rotations, raises important but
challenging questions: Are investors or analysts actually aware of the audit partner’s identity? Do
investors or analysts actually pay attention to audit firm or audit partner tenure? If investors or
analysts are not aware of the audit partner’s identity or do not consider their tenure when making
earnings forecasts or pricing stocks, then our results must be driven by omitted variables or some
other explanation. Future research may identify omitted variables that have the same nonlinear
relationship with the ex ante cost of capital that we observe for non-Big 4 audit partner tenure.
While it is questionable whether investors or analysts are sufficiently aware of auditor-partner
identity to affect earnings forecasts or pricing, there are some reasons why Australian investors and
analysts might be aware of an audit partner’s identity. Because audit reports in Australia are signed
in the name of the audit engagement partner and the audit firm, investors’ and analysts’ cognizance
of audit partners’ names may increase as their tenure increases or as partners report on multiple
engagements. Further, Australian corporations law requires the audit engagement partner to attend
the annual general meeting (AGM) and respond to shareholders’ questions about the financial
report. In addition, anecdotal evidence obtained through our discussions with five analysts indicates
that they sometimes contact the engagement partner with questions about the financial report.
If investors do pay attention to auditor tenure, why do we find a tenure effect only for non-Big4
clients? If analysts or investors do recognize an audit partner’s name, mere exposure to their name
may be sufficient to enhance investors’ or analysts’ perceptions of the audit partner’s credibility in
the absence of specific information about an audit partner’s performance. There is support for this
expectation in the psychology and behavioral research literature (Zajonc 1968, 1980; Mandler et al.
1987; Jacoby et al. 1989; Bornstein and D’Agostino 1994; Bonner et al. 2007; Chen and Tan 2011).

February 2013
However, this does not necessarily explain why tenure is significant for non-Big 4 engagements but
not for Big 4 engagements. The difference between Big 4 and non-Big 4 tenure effects may indicate
financial report users moderate their perceptions of the effect of auditor tenure on audit quality
according to auditor type (Big 4 and non-Big 4); this may arise for at least two reasons. First,
partners from a smaller audit firm may be perceived as lacking expertise until they have had some
experience with the particular client, because of limited in-house resources. Second, perceptions of
auditor independence may be negatively affected by long tenures of partners from smaller audit
firms because they may appear to be more dependent on particular clients, and, therefore, less able
to resist client pressure. This discussion suggests there may be two market-awareness effects, a
partner-name effect and brand-value effect, and that Big 4 brand value dominates partner name.
Testing these effects, and whether investors or analysts recognize audit partner identities and tenure,
is beyond the scope of this archival study, and is left to future research. Surveys and experiments
involving analysts and investors are likely to be fruitful in this regard.
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Auditing: A Journal of Practice & Theory American Accounting Association

Vol. 32, No. 1 DOI: 10.2308/ajpt-50308

Audit Partner Tenure and Cost of Equity

Submitted: January 2010

Auditing: A Journal of Practice & Theory

RESEARCH METHOD AND DATA

Auditing: A Journal of Practice & Theory

Ex Ante Cost of Capital

Auditing: A Journal of Practice & Theory

Controlling for Big 4 Selection Bias

Other Control Variables

Auditing: A Journal of Practice & Theory

SAMPLE SELECTION AND DESCRIPTIVE STATISTICS

Sample Selection and Data

Auditing: A Journal of Practice & Theory

Panel A: Partner Tenure Sample Size by Year

Panel B: Descriptive Statistics for the Pooled Sample

Results for Partner Tenure

Auditing: A Journal of Practice & Theory

Auditing: A Journal of Practice & Theory

(continued on next page)

Auditing: A Journal of Practice & Theory

Panel B: Variables Beta to QualifiedOther

Auditing: A Journal of Practice & Theory

Panel A: Main Results

(continued on next page)

Auditing: A Journal of Practice & Theory

Panel B: Additional Tests on Partner and Firm Tenure

Auditing: A Journal of Practice & Theory

Results for Partner Rotation

Auditing: A Journal of Practice & Theory

Auditing: A Journal of Practice & Theory

FURTHER TESTING OF THE BIG 4/NON-BIG 4 EFFECTS

Auditing: A Journal of Practice & Theory

LIMITATIONS AND FURTHER RESEARCH

Auditing: A Journal of Practice & Theory

Auditing: A Journal of Practice & Theory

Auditing: A Journal of Practice & Theory

Auditing: A Journal of Practice & Theory

Auditing: A Journal of Practice & Theory

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