Almutairi Asimetri 2009

Managerial Auditing Journal
Auditor tenure, auditor specialization, and information

asymmetry Ali R. Almutairi Kimberly A. Dunn Terrance Skantz
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Ali R. Almutairi Kimberly A. Dunn Terrance Skantz, (2009),"Auditor tenure, auditor specialization, and
information asymmetry", Managerial Auditing Journal, Vol. 24 Iss 7 pp. 600 - 623
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MAJ
24,7 Auditor tenure, auditor
specialization, and information
asymmetry
600 Ali R. Almutairi
Accounting Department, College of Business Administration,
Received 22 July 2008
Revised 25 February 2009
Kuwait University, Kuwait City, Kuwait, and
Accepted 20 March 2009 Kimberly A. Dunn and Terrance Skantz
School of Accounting, Florida Atlantic University, Boca Raton, Florida, USA
Abstract
Purpose – The purpose of this paper is to examine the relation between a company’s bid-ask spread, a
proxy for information asymmetry, and auditor tenure and specialization.
Design/methodology/approach – The tests use clustered regression for a sample of 31,689 company-
years from 1992 to 2001 and control for factors known to impact bid-ask spread in cross-section.
Findings – The findings suggest that the market’s perception of disclosure quality is higher and
private information search opportunities are fewer for companies engaging industry specialist
auditors. In addition, the paper finds that information asymmetry has a U-shaped relation to auditor
tenure. This U-shaped relation holds for both specialists and non-specialists; however, the bid-ask
spread for specialists tends to fall below that of non-specialists at all tenure intervals.
Research limitations/implications – The findings may directly result from auditor tenure and
specialization or it may be that those auditor-related characteristics are a subset of concurrent choices
made by the company that impacts disclosure quality.
Practical implications – Companies have incentives to lower information asymmetry and the findings
document that the choice of a specialist auditor and the length of the auditor relationship can
potentially influence this objective.
Originality/value – The paper provides information to academics, regulators, companies, and auditors
concerning the effect of auditor-client relationships on the level of information asymmetry. In
addition, it shows the importance of industry specialization and audit firm tenure on audit quality.
Keywords Auditing, Auditors, Information strategy, Disclosure, Bid offer spreads
Paper type Research paper
I. Introduction
A large body of research examines whether audit quality varies with auditor tenure and
industry specialization[1]. Extant research generally finds that cost of capital is lower,
earnings response coefficients (ERCs) are larger, discretionary accruals are smaller, and
debt ratings are better when companies employ specialists and retain their
Managerial Auditing Journal
Vol. 24 No. 7, 2009 pp. 600- Data availability: The data used in this paper are publicly available from the sources indicated
623 in the text.
q Emerald Group Publishing
Limited 0268-6902 The authors appreciate comments received on earlier versions of this paper from Julia Higgs,
DOI 10.1108/02686900910975341 Jayanthi Krishnan, Mark Kohlbeck, and workshop participants at Florida Atlantic University.
auditors for a number of years. These findings are interpreted as evidence that Auditor tenure,
specialization and longer tenure improve audit quality.
specialization
Information asymmetry is a critical link that justifies studies examining the relation
between audit quality (proxied by specialization and tenure) and cost of capital, ERCs, and and asymmetry
debt ratings. Those studies can be interpreted as exploring whether specialization and tenure
are beneficial to the client company. Our paper complements prior studies by examining
how the bid-ask spread is associated with specialization and tenure. Because the bid-ask 601
spread provides a reasonably direct measure of the market’s perception of information
asymmetry, this paper examines whether a reduction in the market’s perception of
information asymmetry is a mechanism from which benefits of specialization and tenure
documented in prior research might flow.
Our tests use a sample of 31,689 company-years from 1992 to 2001 and control for
factors known to impact bid-ask spread in cross-section. Results indicate that clients
with specialist auditors have lower bid-ask spreads than clients of non-specialist
auditors in the approximately 48 trading-days following the disclosure of audited
financial information. The results are robust across three different measures of
specialization and also robust to whether the three specialization measures are included
in the model as indictor or continuous measures[2].
Our results also show that the bid-ask spread has a U-shaped relation to tenure. After
controlling for the first year of the audit engagement, bid-ask spread is significantly
lower in the second and third year of the engagement than in later sub-periods (four to
nine years, and longer than nine years). In addition, we find no difference in the bid-ask
spread between medium (four to nine years) and long tenure (longer than nine years).
The results suggest that the market views information asymmetry as relatively high in
the first year of an engagement, decreasing in the early years of the engagement and
then increasing later in the engagement. In general, the reduced bid-ask spread in the
early years of an engagement is stronger for clients of specialist auditors.
Our findings are consistent with a market that associates two important auditor
characteristics with audit quality and the market’s perception of information
asymmetry. However, it is unlikely that these two characteristics alone determine the
market’s perception of a company’s financial reporting quality. One conclusion is that a
company’s auditor-related choices are part of a portfolio of concurrent reporting and
disclosure choices that affect the opportunity (need) for private information search.
Our results are important because understanding the effect of auditor tenure and
industry specialization on the market’s perception of information asymmetry may assist
client companies in making auditor-related choices consistent with their overall
disclosure strategy, assist auditors in making strategic and marketing decisions to better
serve their clients, and guide regulators in setting policies consistent with increasing
market transparency.
The remainder of this paper is structured as follows. Section II justifies our choice of
bid-ask spread as a dependent variable, reviews the literature on information
asymmetry and audit quality, discusses the findings of prior research with respect to
specialization and tenure, and develops our three hypotheses. Research design, sample
selection and variable measurement are discussed in Section III. Empirical results,
supplemental analysis and robustness tests are presented in Section IV. Summary and
concluding remarks are presented in Section V of the paper.
MAJ II. Development of hypotheses
24,7 Information asymmetry and the bid-ask spread
The market’s perception of a company’s auditing, reporting, and disclosure quality
will affect the market’s perception of information asymmetry and opportunities for
profitable private information-search activities. The beneficial effects of audits
documented in prior research (e.g. lower cost of capital, larger ERCs, and better debt
602 ratings) may result from a reduction in information asymmetry and private
information production. For example, Pittman and Fortin (2004) state that big six
auditors can enhance the credibility of financial statements and obviate the need for
lenders “[. . .] to conduct costly information production and monitoring using
alternative sources [. . .].” In other words, audits are efficient ways to reduce agency
costs and private information production. Accordingly, audits of higher quality should
be associated with lower levels of information asymmetry and private information
production among investors.

One way to characterize information asymmetry is the extent to which managers
know more about the firm than investors as a group. A second characterization is the
extent to which the amount of information regarding the firm varies from one group
of investors to another (Watts and Zimmerman, 1986). Among investors in public
markets, information asymmetry is predicated on the existence of uninformed
(liquidity) traders and informed traders. Informed traders have an incentive to trade on
private information that is expected to become public.
Bid-ask spread is the difference between the bid price a dealer is willing to pay for
a security and the higher ask price at which the dealer is willing to sell a security. An
increase in information asymmetry increases the risk that a market maker will trade
with an informed investor and will be reflected in a higher bid-ask spread for a
security (Callahan et al., 1997). After controlling for inventory and transactions cost
components, bid-ask spreads provide a reasonably direct measure of the market’s
perception of information asymmetry (Kim and Verrechia 1994, 2001; Leuz and
Verrecchia, 2000).
After an earnings announcement, information asymmetry among investors will
reflect the extent to which financial statements resolve or fail to resolve uncertainty
about company value[3]. As audit quality and the credibility of a firm’s financial
disclosures increase, earnings announcements will better resolve uncertainty about
company value, reduce the level of information asymmetry and result in lower levels
of bid-ask spread[4].
Audits, auditor industry specialization, and audit quality

Audits are one way to reduce information asymmetry and associated agency costs.
Since higher quality audits are more likely to detect and avoid accounting errors and
misstatements than lower quality audits, higher quality audits should reduce
information asymmetry more than lower quality audits.
Both experimental and archival studies find a positive relation between industry
specialization and various direct and indirect measures of audit quality. Experimental
research finds that industry specialization improves performance on a variety of audit
tasks. Specialists in the banking industry are more confident than non-specialists in
assessing inherent risk (Taylor, 2000); audit managers and senior auditors are better at
detecting errors when they conduct audit tasks in industries within their specialization
(Owhoso et al., 2002); and, specialist auditors are more adept than non-specialists at Auditor tenure,
interpreting an incomplete pattern that suggests a misstatement (Hammersley, 2006).
specialization
Archival studies have examined the relation between industry specialization and
measures of earnings quality. Relative to clients of non-specialist auditors, clients of and asymmetry
specialists have significantly lower absolute discretionary accruals (Krishnan, 2003),
and larger ERCs at earnings announcement dates (Balsam et al., 2003). Dunn and
Mayhew (2004) find a positive relation between the employment of an industry 603
specialist auditor and analysts’ perceptions of disclosure quality.
In addition, there is evidence that specialists receive a fee premium from clients in
their industry of expertise (Craswell et al., 1995; DeFond et al., 2000) and that
specialization may lead to scale economies (Cairney and Young, 2006; Houghton et
al., 2005; Mayhew and Wilkins, 2002). Fee premiums and production efficiencies
could imply that specialists are more profitable than non-specialists and may have
more reputation capital at stake. In that case, specialists would be less likely to
compromise their independence and more likely to report generally accepted
accounting principles (GAAP) violations[5].
Taken together, prior research suggests a positive relation between audit firm
specialization and both financial reporting quality and audit quality. This research provides
indirect evidence about the relation between industry specialization and the market’s
perception of a company’s disclosure quality. If the market shares the view that industry
specialist auditors ensure more complete, relevant, and reliable information, we would
expect companies with specialist auditors to exhibit lower levels of information
asymmetry as reflected in a lower bid-ask spread. On the other hand, the market may view
specialization primarily as a means through which audit firms increase the profitability of
audit engagements (as a result of increased efficiency, reduced competition, and higher
audit prices) but with little or no effect on audit quality. Similarly, the market may
anticipate that specialists will enforce strict adherence to GAAP which could be viewed as
enhancing reporting quality or as blocking the communication of inside information. Thus,
while we state a directional hypothesis, findings in the literature do not resolve how the
market perceives the opportunities for private information search for clients of specialist
versus non-specialist auditors:
H1. The level of information asymmetry as measured by the bid-ask spread is
lower for clients of specialist than non-specialist auditor.
Audit firm tenure and audit quality

As discussed fully in Carcello and Nagy (2004) and Myers et al. (2003), the effect of
tenure on audit quality is controversial. Proponents of mandatory audit firm rotation
argue that longer tenure can lead to reduced auditor independence, increased
complacency and reduced objectivity. On the other side are those who contend that
audit quality increases with tenure because with experience the auditor becomes more
familiar with the client’s business operations and reporting issues.
Most studies find evidence consistent with a positive association between audit quality
and auditor tenure. Libby and Frederick (1990) find that experience auditors exhibit better
understanding of financial errors and have lower error frequency rates. Myers et al. (2003)
find that absolute discretionary and current accruals are decreasing in tenure, and Carcello
and Nagy (2004) conclude that the incidence of fraudulent reporting decreases with tenure.
Similarly, Mansi et al. (2004) find the cost of debt is
MAJ decreasing with auditor tenure; and Ghosh and Moon (2005) report that ERCs are
24,7 increasing with tenure. These studies suggest that longer tenure is associated with
increased earnings quality and reduced cost of capital. Conversely, Myers et al.
(2005) find that income-increasing misstatements are more likely as tenure increases.
Most, but not all, prior studies suggest a positive relation between auditor tenure
and proxies for audit quality, and are generally inconsistent with the position that
604 longer auditor-client relationships compromise independence-in-fact and/or
appearance. However, the evidence does not directly address how the market views
tenure. The market could perceive longer tenure as enhancing the economic bond
between the auditor and client, or as increasing the expertise of the auditor. In the
second case, and consistent with most academic research, we expect to find the bid-
ask spread is decreasing with auditor tenure. With that in mind, our H2 is:
H2. The level of information asymmetry as measured by the bid-ask spread

decreases with audit firm tenure.
Specialization and tenure interaction effects

Our H3 predicts that the association between tenure and bid-ask spread will differ for
specialist and non-specialist auditors. The predicted interaction effects are based on
research that finds the relation between tenure and audit quality varies between
specialist and non-specialist auditors. For example, Fung et al. (2007) find higher
discretionary accruals for short tenure auditors when they are non-specialists, but find
no relation between tenure and discretionary accruals for specialists. In addition,
Myers et al. (2005) find that income-increasing financial statement misstatements are
more likely as tenure increases, but only for non-specialist auditors.
There are theoretical reasons to expect tenure to have different effects on audit
quality for specialists and non-specialists but the direction of the effect is not clear. If
tenure provides non-specialists with expertise similar to that possessed by specialists,
information asymmetry may be decreasing with tenure for non-specialists auditors but
that association may be absent or smaller for specialists. Additionally, the (presumed)
economic rents earned by specialists may be viewed by the market as increasing the
likelihood that specialist auditors will acquiesce to a client’s questionable reporting
choices and that the likelihood that such acquiescence has and will continue to occur
is increasing with tenure. Alternatively, the market may expect that specialist auditors
will protect their reputation capital and the associated rents by being more willing to
withdraw from an engagement over disputes with the client. If longer tenure reduces
audit quality due to impaired independence, specialists may be at least partially
immune because they earn higher economic rents from fee premiums or scale
economies than non-specialists and thus have more to lose in the event of audit
failure. Given the competing theories, we do not make a directional prediction:
H3. The association between tenure and bid-ask spread differs for specialist and
non-specialist auditors.
III. Research design

Information asymmetry model specification
The effect of auditor tenure and specialization on information asymmetry will be due,
at least in part, to the market’s assessment of the quality of the audited annual report.
As a result, and as discussed above, we examine bid-ask spread in the period Auditor tenure,
following the announcement of annual earnings and prior to the release of the
subsequent first quarter earnings.
specialization
For each company-year during 1992-2001, we measure bid-ask spread and certain and asymmetry
control variables over the interval starting seven days after the annual earnings
announcement for fiscal year t and ending seven days before the first quarterly
earnings announcement for fiscal year t þ 1 (Ertimur, 2004). This time interval is used 605
to capture the level of information asymmetry conditional on disclosures in the
audited annual report while avoiding the short-term increase in information
asymmetry known to accompany earnings announcements[6]. Our selection of a
relatively short measurement window (approximately 48 trading days) should
increase the power of our tests. A long measurement window increases the likelihood
that the number of information events will vary across companies, yielding a noisy
measure of cross-sectional differences in the level of information asymmetry

following audited earnings announcements. Muller and Riedl (2002), for example,
measure bid-ask spread over a seven-month period and fail to find a link between
spread and auditor quality (i.e. big six auditors).
Variables. Bid-ask spread. We use relative bid-ask spread (SPREAD) as our proxy
for information asymmetry and limit the sample to National Association of Securities
Dealers Automated Quotations (NASDAQ) listed companies to avoid different
trading environments between dealer (NASDAQ) and auction (NYSE) markets. The
SPREAD is found for each day during our post earnings announcement measurement
window and is calculated as (b 2 a)/m, where b is the closing bid price, a is the
closing ask price, and m is the mid-point between b and a. The Center for Research in
Security Prices (CRSP) database is used as the source of the bid-ask spread. SPREAD
for each company-year observation is measured as the median of the daily SPREAD
over the measurement window[7].
Industry specialization. Although auditor industry specialization is a growing area
of interest in academic research, a single measure of specialization has not emerged
(Neal and Riley, 2004). The two primary ways of identifying industry specialization
are industry market share (Balsam et al., 2003; Dunn and Mayhew, 2004) and auditor
portfolio share (Krishnan, 2003). In addition, Neal and Riley (2004) propose a new
composite measure that is a function of both market share and portfolio share. We
include all three measures of specialization in our analysis[8].
The market share measure of specialization assumes that a firm that audits a
sufficiently large percentage of companies in a particular industry is a specialist in
that industry. For each year t, our first measure of industry specialization is based on
an auditor’s market share for industry k. Suppressing the t subscript, audit firm i’s
market share in industry k for year t is MKTSHRik and is found as follows:
P J ik SALES ijk
I k
MKTSHRik j¼1 J
ik
1
¼P P ðÞ
i¼1 j¼1SALESijk
where i, an index of auditors (i ¼ 1, 2, 3, 4, 5, 6); j, an index of client companies; k, an index of
audited industries; Ik, the number of auditors in industry k; Jik, the number of clients audited by
auditor i in industry k; and SALESijk, sales revenue for auditor i’s client j.
MAJ We use both the continuous market share measure and an indicator variable in our
24,7 analysis. The indicator variable is defined following Balsam et al. (2003) by
classifying an auditor as a specialist in industry k if they have the highest market
share in industry k and if that share exceeds the share of the auditor with the second
highest market share by at least 10 percent.
Our second measure of industry specialization is based on how important each
606 industry is to an auditor’s total client portfolio (Krishnan, 2003). Our portfolio share
measure of industry specialization is based on the proportion of audit firm i’s portfolio
represented by industry k in year t. Suppressing the t subscript, portfolio share is
found as follows:
P J ik ik
SALESijk
PORTSHRik K j¼1 J 2
¼P P SALES ðÞ
k¼1 j¼1 ijk
where SALES and all indices are defined as in equation (1).
We use both the continuous portfolio share measure and an indicator variable in
our analysis. For the indicator variable, audit firm i is classified as a specialist in
industry k if the portfolio share for industry k is in the top 10 percent of audit firm i’s
portfolio share for all K industries in year t. The audit firm is classified as a non-
specialist in all other industries for that year.
Our third measure of industry specialization is based on a composite measure
proposed by Neal and Riley (2004). Their measure incorporates both the audit firm’s
industry market share and the industry’s share of the auditor’s portfolio[9]. For our
continuous composite variable, we include the product of market share and portfolio
share from equations (1) and (2). For our indicator variable, the product of
MKTSHRik and PORTSHRik from equations (1) and (2) is compared to the weighted
market share cut-off (WMSCO), where:
WMSCO ¼ 1 £ 1:2 1
N £N ð3Þ
audit firms industries
If the product, MKTSHRik £ PORTSHRik, for year t is greater than the weighted cut-
off, audit firm i is classified as a specialist in industry k for year t. Otherwise, the audit
firm is classified as a non-specialist.
Tenure. Auditor tenure is based on the length of the auditor-client relationship as
reported by Compustat. Following prior research, we use both continuous (Myers et
al., 2003; Ghosh and Moon, 2005) and indicator variables (Carcello and Nagy, 2004)
for tenure in our analysis. Our continuous measure for tenure is the number of
consecutive years of the auditor-client relationship as reported on Compustat[10].
Following Carcello and Nagy (2004), we use tenure to create indicator variables. We
classify the first year of the auditor-client relationship as CHANGE, the second and
third year as SHORT, and any tenure that is ten years or longer as LONG[11].
Medium tenure (from four to nine years) is the benchmark group in our regression
models using indicator variables.
Control variables in bid-ask spread regressions. A market maker or dealer functions to
increase the liquidity in shares by making shares of a stock immediately available
(Demetz, 1968). The bid-ask spread is the price a dealer charges to recover the costs of
his or her services. The dealer faces three types of costs – inventory holding costs, Auditor tenure,
order processing costs, and the cost of adverse selection. The variables in our specialization
regression equation that control for inventory holding costs and order processing costs
are based on Stoll’s (1978) model. and asymmetry
Holding costs are a function of the risk aversion and equity of the dealer, price
volatility, holding period, and value of each transaction. As a dealer’s risk aversion
(equity wealth) increases, holding costs increase (decrease). Dealer risk aversion and 607
wealth are not observable and are thus assumed to be constant across dealers;
therefore, we do not include proxies for these variables in our analysis.
Price volatility affects holding costs because higher volatility increases the risk of
adverse price changes for the market maker. As price volatility increases, an order at
the bid exposes the market maker to the risk of price decline and an order at the ask
exposes the market maker to the risk of price increases. The variance of return is used
to measure price volatility. Thus, higher stock price variability is associated with a
higher bid-ask spread. Price volatility risk is exacerbated as the probability of dealing
with informed traders increases. VOLATILITY is measured as the standard deviation
of daily security returns during our measurement window.
Longer holding periods increase holding costs. Trading volume is a proxy for the
holding period since higher trading volume increases the ease with which a dealer can
reverse a position. Market makers can reduce inventory levels for firms with higher
trading volume because arrival of buy and sell orders are more predictable (McInish
and Wood, 1992). Higher volume also provides market makers with more
opportunities to recover losses to informed traders through trades with liquidity
traders (Roulstone, 2003). Consistent with Stoll’s model, Gregoriou et al. (2005) find
the bid-ask spread is positively associated with volatility and negative associated with
trading volume. To control for the expected negative relation between trading volume
and bid-ask spread, we first find daily turnover computed as the number of shares
traded each day during our measurement window scaled by the number of shares
outstanding that day. For each company-year, TURNOVER is defined as the median
daily turnover during the measurement window.
The larger the transaction size, the larger the holding costs. Share price serves as a
proxy for the value of each transaction since price quotes are for standard lot sizes
(100 shares). In addition, price is related to order processing costs; processing costs
are a fixed amount per trade and are decreasing with the value of the transaction. In
Stoll’s model, the association between relative spread and price would be positive if
holding costs dominate and negative if order processing costs dominate. Additionally,
there also is a mechanical link between relative spread and stock price that is expected
to lead to a negative association between the two (Roulstone, 2003). Thus, stock price
handles a number of roles in our model and the coefficient should reflect the average
effect of different factors. The variable PRICE for any company-year is the median
closing daily stock price during the measurement window.
In addition to variables to control for holding and order costs, we include variables that
affect a market maker’s adverse selection risk. Research demonstrates a positive relation
between company size and the amount of publicly available information; thus market
makers face a lower risk of adverse selection for larger companies (Atiase, 1985). To
control for the negative relation between company size and bid-ask spread, we include a
variable for market value (Gregoriou et al., 2005). We calculate the market
MAJ value of common equity for each day during the measurement window. MKTVAL for
24,7 each company-year is then defined as the median daily market value of common
equity over the measurement window.
The amount of public information is expected to increase with the number of
analysts following a company, thereby reducing the expected returns to private
information search. While evidence is mixed (Roulstone, 2003), recent studies find
608 that market liquidity is increasing (i.e. information asymmetry is decreasing) as the
number of analysts increase (Muller and Riedl, 2002; Roulstone, 2003; Yohn, 1998).
We include the variable ANALYSTS in our model, found as the number of analyst
issuing a forecast for annual earnings per share for year t. Companies not in the
Institutional Brokers’ Estimate System (I/B/E/S) database are treated as having no
analyst coverage[12].
Finally, we include company age to control for the positive association between
audit firm tenure and company age (Myers et al., 2003; Carcello and Nagy, 2004;
Ghosh and Moon, 2005). AGE is found as the number of years since the company’s
annual financial statement was first available on Compustat[13].
Regression models. We estimate two regression models to test for cross-
sectional differences in bid-ask spreads for clients of specialist versus non-specialist
auditors and clients of shorter versus longer-tenure auditors. Both include the same
control variables and both have an indicator variable (CHANGE) to capture the effect
of new audit engagements on bid-ask spread. The first model, equation (4), uses
indicator variables for specialization and tenure; the second model uses continuous
variables for both:
SPREAD ¼ V0 þ V1TURNOVER þ V2VOLATILITY þ V3MKTVAL

þ V4PRICE þ V5ANALYSTS þ V6AGE þ SV7215YEAR ð4Þ
þ V16SPECI þ V17CHANGE þ V18SHORT þ V19LONG þ 1
SPREAD ¼ b0 þ b1TURNOVER þ b2VOLATILITY þ b3MKTVAL

þ b4PRICE þ b5ANALYSTS þ b6AGE þ Sb7215YEAR ð5Þ
þ b16SPECC þ b17CHANGE þ b18TENURE þ 1
where:
SPREAD – is the median of the relative daily bid-ask spread over the
measurement window where relative daily bid-ask spread is
defined as (BID 2 ASK)/{(BID 2 ASK)/2}, BID is the daily
closing bid price, and ASK is the daily closing ask price.
TURNOVER – is the median scaled trading volume over the measurement
window where scaled trading volume is defined as
[VOLUME/SHARES] where VOLUME and SHARES are the
daily trading volume and the daily number of shares outstanding,
respectively.
VOLATILTY – is the standard deviation of daily returns over the measurement
window.
MKTVAL – is the median market value over the measurement window where Auditor tenure,
*
market value is defined as (PRC SHARES), where PRC is daily specialization
closing price.
PRICE – is the median closing daily share price over the measurement window. and asymmetry
ANALYSTS – is the number of analysts issuing a forecast for annual earnings per
share for year t. 609
AGE – is the number of years since annual financial statements were first
available on Compustat.
YEAR – is an indicator variable to control for fixed year effects.
SPECI – is one of three indicator specialization variables (market share,
portfolio share, or composite measure as defined in the section

describing industry specialization variables).
SPECC – is one of three continuous specialization variables (market share,
portfolio share, or composite measure as defined in the section
describing industry specialization variables).
TENURE – is the number of consecutive years of the auditor-client relationship.
CHANGE – is equal to 1 if TENURE ¼ 1, and 0 otherwise.
SHORT – is equal to 1 if 2 # TENURE # 3, and 0 otherwise.

LONG – is equal to 1 if TENURE $ 10, and 0 otherwise.
(MEDIUM where 4 # TENURE # 9 is not represented in equation
(4) because medium tenure audit engagements serve as the
benchmark in the dichotomous tenure equation).
Because the sample is drawn from panel data, we expect serial autocorrelation of the
independent variables and the error term within companies. As discussed by Petersen
(2009) and shown through his simulation results, t-statistics based on average
regression coefficients from year-by-year regressions using the methodology of Fama
and MacBeth (1973) are biased upwards and potentially quite severely in situations
where within company correlation exist. By contrast, clustered regression (clustering
by company) corrects for the serial correlation in panel data and provides unbiased t-
statistics. Additionally, there is evidence of a systematic decline in the bid-ask spread
over the time period in this study[14], possibly due to changes in tick sizes (from 1/8
to 1/16 and finally to decimals) and changes in order handling rules (Barclay et al.,
1999) during our sample period. Thus, we use a fixed-effects model with indicator
variables for years to control for year-to-year changes in the bid-ask spread.
Sample selection
Our sample is restricted to publicly traded companies in the USA that were audited by
big N auditors for fiscal years ending 1992-2001 and that are traded through
NASDAQ. This time period is chosen to limit the number of mergers that occurred
among the big N audit firms and to avoid the audit market changes that resulted from
the demise of Arthur Andersen LLP[15].
MAJ The sample is limited to companies audited by big N audit firms for two reasons.
24,7 First, these large audit firms audit nearly 90 percent of publicly held companies in
the USA (Wallace, 1998). Second, there is substantial evidence that larger audit
firms deliver higher quality audits in part because of product differentiation between
big N and non-big N audit firms (Palmrose, 1986; Menon and Williams, 1991).
Clients of larger audit firms have higher ERCs (Teoh and Wong, 1993), lower
610 discretionary accruals (Becker et al., 1998), and lower cost of debt (Wallace, 1981;
Mansi et al., 2004). As a result, this paper includes only the companies employing
one of the big N audit firms to avoid any differences in bid-ask spread due to audit
firm size effect.
Our analysis requires daily closing bid, closing ask, number of shares traded (for
volume), daily returns (for volatility), number of shares outstanding and closing
price from the CRSP database. In addition, we require total assets, audit firm, and
earnings release dates from the Compustat database, and analyst following from
I/B/E/S. Consistent with Neal and Riley (2004) we exclude from the analysis in year
t any industry with fewer than 20 companies audited by big N auditors[16]. Our data
requirements resulted in a final sample of 31,689 usable company-year observations.
The number of observations in a single year varies from a low of 1,820 in 1992 to a
high of 3,795 in 1999.
IV. Empirical results

Descriptive statistics
Table I shows the number of company-year observations in our sample by industry.
A total of 55 industries are represented with the number of company year
observations in an industry ranging from 12 (0.04 percent of the sample) in leather
and leather products (Standard Industrial Classification – SIC 31) to 4,507 (14.2
percent of the sample) in business services (SIC 73). No other single industry
represents more than 10 percent of the company-year observations.
Table II shows definitions for all variables reported in the descriptive statistics
and used in the analysis. Table III shows descriptive statistics for the pooled sample.
Approximately, 18.5 percent of sample companies are audited by an industry
specialist when specialization is defined by our market share measure. The
percentage of the companies in our sample that are audited by a specialist drops to
16.8 percent when specialization is defined by our portfolio measure and increases to
43.6 percent when specialization is defined by our composite measure. Slightly less
than 25 percent of the company-year observations have an auditor-client relationship
of two to three years, 49 percent have an auditor-client relationship of four to nine
years, and 22 percent have an auditor-client relationship of ten years or longer.
Approximately, 5 percent of company-years represent auditors in their first year with
a client.
The mean (median) market value of the companies included in our sample is
$1.20 ($0.15) billion with the 25th (75th) percentile equal to $0.05 billion ($0.55
billion). Accordingly, the companies in our sample represent a wide range of
company sizes with a skewed distribution. The mean (median) share price is $17.27
(11.88) with the 25th (75th) percentile equal to $5.49 ($23.25).
Pearson and Spearman correlation coefficients are shown in Table IV. All
correlations between our specialization measures are statistically significant ( p ,
0.001). There is much stronger correlation between the composite measure and both
the market share (0.715) and portfolio share measures (0.918). In general, longer
Auditor tenure,
Two-digit SIC code Name of industry Number of company-years
specialization
10 Metal mining 246
and asymmetry
13 Oil and gas extraction 1,119
15 General building contractors 213
16 Heavy construction contractors 74
17 Construction special trade 32 611
20 Food and kindred products 527
22 Textile mill products 199
23 Apparel and other finished products 286
24 Lumber and wood products 126
25 Furniture and fixtures 173
26 Paper and allied products 242
27 Printing publishing and allied 338
28 Chemicals and allied products 2,551

29 Petroleum and coal products 82
30 Rubber and miscellaneous plastics products 367
31 Leather and leather products 12
32 Stone, clay, glass, and concrete products 161
33 Primary metal industries 456
34 Fabricated metal products 397
35 Industrial machinery and equipment 2,120
36 Electrical and electronic equipment 2,632
37 Transportation equipment 590
38 Instruments and related products 2,243
39 Miscellaneous manufacturing industries 340
40 Railroad transportation 80
42 Motor freight transportation and warehousing 339
44 Water transportation 117
45 Transportation by air 186
47 Transportation services 96
48 Communications 1,065
49 Electric, gas, and sanitary services 1,198
50 Durable goods wholesale 744
51 Nondurable goods wholesale 396
Building materials, hardware, garden supply, and
52 mobile 42
53 General merchandise stores 178
54 Food stores 184
55 Automotive dealers and gasoline service stations 131
56 Apparel and accessory stores 345
57 Furniture, home furnishings and equipment stores 171
58 Eating and drinking places 554
59 Miscellaneous retail 629
61 Non-depository credit institutions 418
62 Security and commodity 420
63 Insurance carriers 1,317
64 Insurance agents, brokers, and services 197
65 Real estate 207
67 Holding and other investment offices 248 Table I.
70 Hotels, rooming houses, and other lodging places 120 Distribution of sample
72 Personal services 43 company-years by
(continued) industry
MAJ
Two-digit SIC code Name of industry Number of company-years
24,7
73 Business services 4,507
78 Motion pictures 240
79 Amusement and recreational services 354
80 Health services 755
612 82 Educational services 111
83 Social services 52
Table I. 87 Engineering and management services 719
SPREAD The median of the relative daily bid-ask spread over the measurement window where
relative daily bid-ask spread is defined as (bid-ask)/{(bid-ask)/2}, bid is the daily
closing bid price, and ask is the daily closing ask price
SPECC One of three continuous variables for specialization (market share, portfolio share, or
a composite measure) as defined fully in the body of the paper
SPECI One of three indicator variables for specialization (market share, portfolio share, or a
composite measure) as defined fully in the body of the paper
TENURE The consecutive number of years of the auditor-client relationship
CHANGE Equal to 1 if TENURE ¼ 1 (the first year of the auditor-client pair), and 0 otherwise
SHORT Equal to 1 if 2 # TENURE # 3, and 0 otherwise
MEDIUM Equal to 1 if 4 # TENURE # 9, and 0 otherwise
LONG Equal to 1 if TENURE $ 10, and 0 otherwise
TURNOVER The median scaled trading volume over the measurement window where scaled
trading volume is defined as (volume/number of shares outstanding) where volume
and number of shares outstanding are the daily trading volume and the daily number
of shares outstanding
VOLATILTY The standard deviation of daily returns over the measurement window
MKTVAL The median market value over the measurement window where market value is
defined as (price £ number of shares outstanding), where price and number of shares
outstanding are daily closing prices and daily number of shares outstanding
PRICE The median daily share price over the measurement window
Table II. ANALYSTS The number of analyst issuing a forecast for annual earnings per share for year t
AGE The number of years since annual financial statements were first available on
Variable definitions Compustat
tenure auditors are more likely to be specialists, but there is little evidence that tenure
and specialization are linked in an economically meaningful way. AGE and TENURE
are strongly positively correlated (Pearson correlation ¼ 0.59). Thus, controlling for
company age in our regression models will provide cleaner measures of the
association between tenure and bid-ask spread.
Regression results
Table V shows regression results for H1 and H2. SPREAD is our proxy for
information asymmetry. Regression results are presented separately for each of our
three specialization measures.
In Panel A, we report results using indicator variables for specialization along with
categorical variables for tenure length (SHORT and LONG). We also include the
indicator variable, CHANGE, to capture any first-year auditor effects. We refer to
these as our indicator variables models.
Variable
a N Mean Median 25th percentile 75th percentile Auditor tenure,
specialization
SPREAD
SPECI
31,689 3.514 2.353 1.207 4.416 and asymmetry
Industry share 31,689 0.185 0 0 0
Portfolio share 31,689 0.168 0 0 0
Composite 31,689 0.436 0 0 1.000 613
SPECC
Industry share 31,689 0.198 0.161 0.106 0.252
Portfolio share 31,689 0.033 0.022 0.008 0.046
Composite 31,689 0.009 0.003 0.001 0.009
CHANGE 31,689 0.052 0 0 0
SHORT 31,689 0.246 0 0 0
MEDIUM 31,689 0.487 0 0 1.000
LONG 31,689 0.215 0 0 0

TENURE 31,689 6.323 5.000 3.000 9.000
TURNOVER 31,689 0.447 0.240 0.097 0.531
MKTVAL ($billions) 31,689 1.196 0.152 0.049 0.552
VOLATILITY 31,689 0.042 0.035 0.024 0.052
PRICE 31,689 17.271 11.875 5.490 23.250
ANALYSTS 31,689 5.043 3.000 1.000 7.000
AGE 31,689 11.897 8.000 6.000 14.000 Table III.
a
Note: See Table II for variable definitions Descriptive statistics
In Panel B, we use continuous measures for each of the three specialization variables
and a continuous measure for tenure (TENURE); the variable CHANGE is again
included. We refer to these as our continuous variables models. Although we use a
fixed effect model, Table V does not report year-by-year fixed effects for parsimony.
Each of the fixed effects is significant ( p-value , 0.001) and decreases almost
monotonically from 2.77 for 1992 to 0.526 for 2001[17].
All control variables are statistically significant and, except for company size
(MKTVAL), each carries the sign that is expected based on prior empirical studies.
Bid-ask spread is increasing in volatility and company size (MKTVAL) and
diminishing in turnover and stock price. Because of the unexpected relation between
bid-ask and MKTVAL and the high correlation between MKTVAL and stock price
(0.814) and analyst following (0.649), we estimated the regression equation without
PRICE and ANALYSTS. The result of this analysis, show the expected negative ( p ,
0.01) relation between bid-ask spread and MKTVAL. We also find that bid-ask spread
is increasing reliably with company age suggesting that the market perceives more
opportunities associated with private information search for older companies.
The coefficient on specialization is negative and statistically significant for each of the
three measures. Our continuous market share measure of specialization is the least
significant (two-tailed p-value ¼ 0.031); all other coefficients are significant at p-values
less than or equal to 0.003. These results are consistent with a market that associates
higher audit quality with companies choosing an industry specialist auditor. As a gauge of
the economic significance, consider results for our indicator measures of specialization.
For companies audited by specialists, the bid-ask spread is lower than the sample average
by as much as 10 percent (20.363 coefficient for the composite
Spearman correlation
Table IV. Pearson and
4
1
6
SPECC
Industry Portfolio MKTVAL
a SPREAD share share Composite TENURE TURNOVER ($ billions) VOLATILITY PRICE ANALYSTS AGE
Variable
* * * * * * * * *
SPREAD 1.000 20.108 20.163 20.167 20.104 20.546 20.744 0.262 20.663 20.519 20.056 *
SPECC * * * * * * * * * *
Industry 20.068 1.000 0.416 0.715 0.039 0.034 0.115 20.038 0.080 0.109 0.037
share * * * * * * * * *
Portfolio 20.095 0.412 1.000 0.918 0.002 0.121 0.154 0.018 0.115 0.093 0.023
share * * * * * * * * *
Composite 20.074 0.595 0.917 1.000 0.015 0.109 0.161 0.004 0.114 0.115 0.028
TENURE 20.072 * 0.044 * 0.042 * 0.049 * 1.000 20.023 * 20.121 * 20.174 * 0.089 * 0.134 * 0.590 *
TURNOVER 20.271 * 0.014 0.041 * 0.022 * 20.030 * 1.000 0.390 * 0.234 * 0.311 * 0.414 * 20.147 *
MKTVAL 20.087 * 0.051 * 0.075 * 0.066 * 0.091 * 0.046 * 1.000 20.397 * 0.814 * 0.649 * 0.100 *
VOLATILITY 0.295 * 20.013 20.039 * 20.038 * 20.154 * 0.270 * 20.060 * 1.000 20.503 * 20.227 * 20.286 *
PRICE 20.361 * 0.061 * 0.113 * 0.087 * 0.090 * 0.283 * 0.292 * 20.230 * 1.000 0.507 * 0.084 *
ANALYSTS 20.319 * 0.105 * 0.099 * 0.084 * 0.173 * 0.236 * 0.370 * 20.190 * 0.445 * 1.000 0.043 *
AGE 20.059 * 0.057 * 0.133 * 0.124 * 0.449 * 20.127 * 0.110 * 20.256 * 0.159 * 0.177 * 1.000
* a
Notes: Significance at the 1 percent level; see Table II for variable definitions; pearson correlation coefficients appear below the diagonal; spearman correlation
coefficients appear above the diagonal
a a b c
Auditor tenure,
Variable
Predicted sign Industry share Portfolio share Composite specialization
and asymmetry
Panel A: indicator variables for tenure and specialization
SPREAD ¼ V0 þ V1TURNOVER þ V2VOLATILITY þ V3MKTVAL þ V4PRICE
þV5ANALYSTS þ V6 AGE þ SV7 215YEAR þ V16 SPECI þ V17 CHANGE þ V18SHORT
þV19LONG þ 1 615
Coefficient estimates (p-values) for the indicator specialization measures
Intercept ? 1.371 (,0.001) 1.360 (,0.001) 1.452 (,0.001)
TURNOVER 2 21.581 (,0.001) 2 1.579 (,0.001) 21.574 (,0.001)
VOLATILITY þ 53.462 (,0.001) 53.348 (,0.001) 53.490 (,0.001)
MKTVAL 2 0.027 (,0.001) 0.0272 (,0.001) 0.027 (,0.001)
PRICE ? 20.035 (,0.001) 2 0.035 (,0.001) 20.034 (,0.001)
ANALYSTS 2 20.087 (,0.001) 2 0.087 (,0.001) 20.086 (,0.001)
AGE ? 0.017 (,0.001) 0.018 (,0.001) 0.018 (,0.001)

SPECI ? 20.178 (0.003) 2 0.272 (,0.001) 20.363 (,0.001)
CHANGE ? 0.021 (0.836) 0.022 (0.823) 0.029 (0.772)
SHORT ? 20.256 (,0.001) 2 0.256 (,0.001) 20.245 (,0.001)
LONG ? 20.032 (0.649) 2 0.034 (0.624) 20.037 (0.594)
R2 0.319 0.319 0.320
Panel B: continuous variables for tenure and specialization
SPREAD ¼ b0 þ b1TURNOVER þ b2 VOLATILITY þ b3MKTVAL þ b4PRICE
þb5ANALYSTS þ b6 AGE þ Sb7215YEAR þ b16 SPECC þ b17 CHANGE þ b18TENURE þ 1
Coefficient estimates (p-values) for the continuous specialization measures
Intercept ? 1.267 (,0.001) 1.309 (,0.001) 1.235 (,0.001)
TURNOVER 2 21.581 (,0.001) 21.570 (,0.001) 2 1.576 (,0.001)
VOLATILITY þ 53.369 (,0.001) 53.415 (,0.001) 53.357 (,0.001)
MKTVAL 2 0.027 (,0.001) 0.027 (,0.001) 0.0270 (,0.001)
PRICE ? 20.035 (,0.001) 20.034 (,0.001) 2 0.035 (,0.001)
ANALYSTS þ 20.086 (,0.001) 20.085 (,0.001) 2 0.086 (,0.001)
AGE ? 0.017 (,0.001) 0.019 (,0.001) 0.018 (,0.001)
SPECC ? 20.448 (0.031) 25.357 (,0.001) 2 9.914 (,0.001)
CHANGE ? 0.184 (0.070) 0.175 (0.086) 0.177 (0.082)
TENURE ? 0.016 (0.057) 0.014 (0.088) 0.015 (0.069)
0.318 0.320 0.319
R2
a Table V.
Notes: See Table II for variable definitions; þ, positive relation between independent and dependent
variable predicted; 2, negative relation between independent and dependent variable predicted; ?, no Multivariate models
relation between independent and dependent variable predicted explaining bid-ask spread
specialization measure, in Panel A column (c), divided by the 3.514 mean spread in
Table III).
The findings do not allow us to conclude that specialists “cause” their clients to
report “better” information or that improved disclosures are limited to audited
financial reports. However, we can infer that specialist auditors are one element of the
reporting and disclosure choices made by a company that – post the annual report
announcement – is related to lower information asymmetry as reflected in market
makers’ quoted bid-ask spreads.
As shown in Panel A, auditors in their second and third years with a client (SHORT)
have significantly lower bid-ask spreads than MEDIUM auditors in their fourth to ninth
year with a client[18]. We find that auditors with tenure of ten or more years
MAJ (LONG) have a bid-ask spread that is not distinguishable statistically from the bid-ask
24,7 spread of auditor with MEDIUM tenure. In further testing (not tabulated here) we find that
SHORT tenure auditors have significantly lower bid-ask spreads than LONG term
auditors[19]. We also find that the bid-ask spread for tenure years two and three is
significantly smaller than the first year bid-ask spread[20]. Thus, there is a U-shaped
relation between bid-ask spread and tenure with a relatively high bid-ask spread in the
616 year of an auditor change, a significant decrease in the second and third years of an
engagement, and a subsequent reversal of that decrease. This is consistent with a market
that perceives the selection of a new auditor as a commitment to and a delivery of higher
quality financial reporting (and potentially better quality disclosures more generally) in the
short run but with a later perception that financial reporting quality gains vanish. The
results suggest that early in an auditor’s tenure, market makers perceive a lower
probability that any given trader has superior private information and that perception
changes later in the auditor’s tenure. We conclude that the bid-ask spread is higher in the
first year of the audit, lower in early years, and higher again after the auditor-client
relationship exceeds some critical number of years.
The coefficient on the continuous variable TENURE is positive and marginally
statistically significant (0.057 , p-values , 0.088 in Panel B). The observed level of
significance may be the result of nonlinearity in the association between bid-ask
spread and tenure shown in Table V, Panel A.
Table VI shows results of our regression models for H3. Because we found that the
effect of tenure is nonlinear in Table V, we use our categorical tenure variables in all
analyses shown in Table VI. In addition, we use all indicator and continuous measures
of specialization shown in Table V. Results are shown for each of those measures as
categorical (Panel A) and continuous (Panel B). The model uses the bid-ask spread of
medium tenure non-specialists auditors as a benchmark and controls for other factors
expected to impact bid-ask spread as in Table V.
First, note that four of our six proxies for specialization are significant at two-tailed
p-values of 0.07 or less. This means that, in general, medium tenure specialists have a
smaller bid-ask spread than medium tenure non-specialists. Second, except for Panel
B column (a), the categorical tenure variable SHORT is negative and significant at a
two-tailed p-value of 0.07 or less. Thus, the favorable bid-ask spread we observe in
Table V for short tenure auditors (which is the average for clients of both specialist
and non-specialist auditors) holds for the subset of companies audited by non-
specialists alone. Specifically, the negative and significant coefficient on SHORT
indicates that the bid-ask spread for short tenure non-specialist auditors is lower than
for medium tenure non-specialists.
Next, our interaction terms allow us to examine if the tenure effects differ between
specialists and non-specialists. The interaction between short tenure and specialization
(SPEC £ SHORT) is significant and negative (two-tailed p-values of 0.029 or less) for
four of our six specialization proxies. Although mixed, the evidence suggests the
favorable bid-ask spread effect of short tenure auditors is more pronounced for
specialists than for non-specialists. In other words, the decrease in the bid-ask effect
for short tenure auditors is more pronounced for specialists than non-specialists.
Further, the reversal of that favorable effect as tenure increases to the medium term is
less pronounced for specialists than non-specialists. Other interaction terms are
largely insignificant.
a a b c
Auditor tenure,
Variable
Predicted sign Industry share Portfolio share Composite specialization
and asymmetry
Panel A: indicator variables for tenure and specialization
þV5ANALYSTS þ V6 AGE þ SV7 215YEAR þ V16 SPECI þ V17 CHANGE þ V18SHORT
þ V19LONG þ V20 SPEC £ CHANGE þ V21SPEC £ SHORT þ V22 SPEC £ LONG þ 1
Coefficient estimates (p-values) for the indicator specialization measures 617
Intercept ? 1.343 (,0.001) 1.332435 (,0.001) 1.435 (,0.001)
TURNOVER 2 2 1.581 (,0.001) 2 1.580 (,0.001) 2 1.573 (,0.001)
VOLATILITY þ 53.502 (,0.001) 53.369 (,0.001) 53.492 (,0.001)
MKTVAL 2 0.027 (,0.001) 0.027 (,0.001) 0.027 (,0.001)
PRICE ? 2 0.035 (,0.001) 2 0.035 (,0.001) 2 0.034 (,0.001)
ANALYSTS 2 2 0.087 (,0.001) 2 0.087 (,0.001) 2 0.086 (,0.001)
AGE ? 0.0171 (,0.001) 0.019 (,0.001) 0.018 (,0.001)

SPECI ? 2 0.055 (0.519) 2 0.146 (0.070) 2 0.334 (,0.001)
CHANGE ? 0.043 (0.709) 0.079 (0.491) 0.032 (0.816)
SHORT ? 2 0.198 (0.002) 2 0.236 (0.002) 2 0.246 (0.002)
LONG ? 0.003 (0.971) 0.024 (0.752) 0.022 (0.817)
SPEC £ CHANGE ? 2 0.119(0.567) 2 0.353 (0.066) 2 0.008 (0.969)
SPEC £ SHORT ? 2 0.327 (0.011) 2 0.117 (0.352) 0.004 (0.968)
SPEC £ LONG
2
? 2 0.183 (0.169) 2 0.334 (0.006) 2 0.137 (0.241)
R 0.319 0.319 0.320
Panel B: continuous variables
þV5ANALYSTS þ V6 AGE þ SV7215YEAR þ V16 SPECC þ V17 CHANGE þ V18SHORT
þV19LONG þ V20 SPEC £ CHANGE þ V21SPEC £ SHORT þ V22 SPEC £ LONG þ 1
Coefficient estimates (p-values) for the continuous specialization measures
Intercept ? 1.362 (,0.001) 1.410 (,0.001) 1.355 (,0.001)
TURNOVER 2 2 1.581 (,0.001) 2 1.572 (,0.001) 2 1.577 (,0.001)
VOLATILITY þ 53.473 (,0.001) 53.487 (,0.001) 53.435 (,0.001)
MKTVAL 2 0.027 (,0.001) 0.028 (,0.001) 0.028 (,0.001)
PRICE ? 2 0.035 (,0.001) 2 0.034 (,0.001) 2 0.035 (,0.001)
ANALYSTS 2 2 0.087 (,0.001) 2 0.087 (,0.001) 2 0.087 (,0.001)
AGE ? 0.017 (,0.001) 0.0185 (,0.001) 0.019 (,0.001)
SPECC ? 2 0.146 (0.615) 2 4.006 (,0.001) 2 5.811 (0.008)
CHANGE ? 0.147 (0.491) 0.137 (0.328) 0.080 (0.505)
SHORT ? 2 0.074 (0.482) 2 0.144 (0.069) 2 0.161 (0.016)
LONG ? 0.012 (0.920) 0.027 (0.766) 0.0129 (0.872)
SPEC £ CHANGE ? 2 0.642 (0.360) 2 3.502 (0.128) 2 7.547 (0.173)
SPEC £ SHORT ? 2 0.951 (0.029) 2 3.108 (0.018) 211.334 (0.0003)
SPEC £ LONG ? 2 0.215 (0.629) 2 1.925 (0.144) 2 5.485 (0.090)
2 0.319 0.320 0.319
R
a
Notes: See Table II for variable definitions; þ, positive relation between independent and dependent Table VI.
variable predicted; 2, negative relation between independent and dependent variable predicted; ?, no Multivariate models
relation between independent and dependent variable predicted explaining bid-ask spread
The effect of tenure on bid-ask spread differs for specialists and non-specialists in a
way that suggests two conclusions. First, short tenure auditors are generally perceived
by the market as a signal that a company is committed to more accurate, relevant and
reliable disclosure and reporting choices. Second, disclosure choices by clients of
short-tenure specialist auditors reduce the market’s perception of the likelihood of
MAJ private information search opportunities more than the disclosure choices by short-
24,7 term non-specialist auditors. Third, sufficiently long auditor-client tenure is generally
associated with a market perception that disclosure quality is deteriorating, but that
this deterioration is less likely for companies with specialists.
Robustness tests to control for biases in specialization measures

618 The auditor portfolio share measure of specialization contains an inherent industry
bias. The bias occurs because total industry sales vary across two-digit SIC industries
in any year; thus, the continuous portfolio measure (which for any auditor is the same
for all clients in a particular industry-year) is positively correlated with industry-year
total sales. As a result, cross-sectional differences in auditor portfolio share for any
company-year will be biased upward (downward) for companies in industries that
have larger (smaller) than average total sales. Thus, observed information asymmetry
effects may be due to lower information asymmetry in larger industries. To control for
this potential industry bias, for each industry in each year we include industry sales
divided by total sales in regression equations (4) and (5). With the percentage of
industry-year sales included in the analysis, the coefficient on the auditor portfolio-
based measure of specialization is no longer significant at conventional levels. This
suggests that the portfolio measure of specialization may be a proxy for industry size
rather than firm specialization.
We next devised a control for our market-based measure of specialization, which
contains a bias related to the degree of concentration and the size of companies within
any industry. To better understand this control, assume that certain industries are
dominated by a few large companies, while other industries have companies of
relatively equal size. Moreover, assume companies are randomly assigned to auditors.
Cross-sectional comparisons of market share for a particular auditor will partially
reflect industry concentration. Also, in industries with heavy concentration, we expect
greater variation in market share than in industries with less concentration. To control
for industry concentration and any effects that may have on industry-specific
information asymmetry, we include the standard deviation of industry-year sales as a
control variable; the results in Table V for our market-based measures of
specialization remains negative and statistically significant ( p-value , 0.05).
V. Summary and conclusions

Prior research has documented a positive relation between audit quality (as measured by
industry specialization and audit firm tenure) and cost of capital, ERCs and debt ratings.
Our study differs from prior research in that we use bid-ask spread, a relatively direct
measure of information asymmetry, to examine the market’s perception of the role of
industry specialization and tenure on audit quality. Our results support the notion that the
beneficial effects of audit quality documented in prior research can be explained, at least
in part, by a reduction in information asymmetry.
Our results indicate a negative relation between specialization and information
asymmetry when specialization is measured using market share, portfolio share, and a
composite measure. The results are robust to indicator and continuous specifications
for our specialization measures. Although our findings for the portfolio measure are
sensitive to inclusion of industry size, our results are consistent with a market that
perceives fewer opportunities for private information search when a company is
audited by a specialist auditor. A reduction in private information search opportunities Auditor tenure,
is expected as disclosure and audit quality improve.
specialization
Our results reveal a U-shaped relation between the length of the auditor-client
relationship and bid-ask spread. The findings for tenure are consistent with a market and asymmetry
that perceives auditor changes as a resolution by a firm to provide more relevant and
reliable disclosures. Specifically, the bid-ask spread is higher in the first year of the
audit engagement, declines in the second and third year of the engagement and 619
increases in the later engagement years[21]. The association between bid-ask spread
and tenure is different for specialist and non-specialists. The market’s perception of the
reduction in information asymmetry for short tenure auditors is more pronounced for
specialists and less of those gains dissipate as tenure increases.
Our findings have implications for academics, regulators, companies, and auditors. First,
future researchers exploring information asymmetry issues should be cognizant of the effect
of auditor-client relationships on the level of information asymmetry. Second, regulators

should be aware that the market takes both industry specialization and audit firm tenure into
consideration when evaluating audit quality. However, it is unlikely that those evaluations
are independent of other factors that are important in forming the market’s perception of a
company’s disclosure and reporting quality. Although most academic research has shown a
positive relation between tenure and audit quality, our study provides some evidence that the
market perceives lower audit quality with longer auditor-client relationships. Finally,
companies and auditors should be aware of the market’s perception of industry
specialization and tenure on perceived audit quality. Companies have incentives to lower
information asymmetry and our findings document that the choice of a specialist auditor and
the length of auditor relationship can potentially influence this objective. We cannot,
however, be certain that it is auditor specialization and tenure alone that affect the market’s
perception of information quality. It is possible that a company’s portfolio of important
disclosure choices varies concurrently with auditor tenure and specialization.
Notes
1. We adopt DeAngelo’s (1981, p. 186) definition of audit quality: “[. . .] the market-assessed
joint probability that a given auditor will both (a) discover a breach in the client’s accounting
system, and (b) report the breach.”
2. The three measures are: the audit firm’s industry market share, the industry of the client as a
proportion of the audit firm’s portfolio, and a composite measure based on market and
portfolio share.
3. The incentive for private information search and the level of information asymmetry among
investors is expected to be particularly high prior to informative, scheduled announcements
(Kim and Verrecchia, 1994). We expect abnormally high levels of information asymmetry in
the period just prior to scheduled earnings announcements and during the subsequent (short)
period when that asymmetry is resolved (Kim and Verrechia, 1994) and investors form new
estimates of company value. In the period surrounding the annual earnings release, bid-ask
spread will increase as dealers protect themselves from adverse selection. As discussed by
Chae (2005), we would expect an increase in bid-ask spread for informative, scheduled
announcements if we use a measurement window starting several days before and ending
several days after an announcement.
4. After the annual earnings announcement, informed traders will concentrate their trading
activity in stocks where information asymmetry remains the highest and liquidity traders
MAJ will tend to avoid those same stocks resulting in relatively high adverse selection costs for
the market maker and relatively high bid-ask spreads.
24,7 5. The specialist fee premium is not apparent in more recent periods (Ferguson and Stokes,
2002), suggesting that any production efficiencies from specialization might result in lower
fees and may not increase audit quality.
6. The use of a seven-day window before and seven-day after the announcement should avoid
620 announcement related bid-ask changes. Krinsky and Lee (1996), for example, use a two-
day window before and two-day window after the earnings announcement to measure the
effect of earnings announcements on components of the bid-ask spread.
7. There are a number of ways to measure the adverse selection component of the bid-ask
spread using intra-day trade data such as NYSE’s Trade and Quote (TAQ) database. The
primary disadvantage of the use of intra-day data for the present study is that computational
costs are quite high and thus the period of analysis is necessarily limited. For example,
Danielsen et al. (2007) examine the association between audit and non-audit fees and a
number of adverse selection measures derived from TAQ data; their study is limited to
August 2001 (and 741 companies). We use the closing bid-ask spread as a proxy for
information asymmetry (controlling for inventory holding and transaction costs
components of the spread) because information asymmetry measures derived from intra-
day data are not feasible for our panel data set. Moreover, van Ness et al. (2001, p. 77)
compare five adverse selection models that use intra-day data and conclude that the models
“measure adverse selection weakly at best”; thus, it is not clear that those other information
asymmetry measures are superior to our proxy at least in the context of this study.
8. All specialization proxies are calculated separately for each year. An audit firm may be
classified as a specialist in industry k in year t but not in year t þ 1. Although we allow for
firms to be reclassified each year, 68 percent of our sample is consistently classified as
either a specialist or non-specialist throughout our sample period. An additional 26 percent
of our sample is reclassified once (i.e. moves from specialist to non-specialist or non-
specialist to specialist) during our sample period.
9. Refer to Neal and Riley (2004) for a more detailed explanation of this composite measure
of specialization.
10. Compustat began reporting auditor codes in 1974; therefore, we are not able to determine
the length of the auditor-client relationship when the initial engagement began prior to
1974. Since our sample period begins in 1992, auditor-client relationships exceeding 18
years are not reliable and we exclude these firm-year observations from our analysis.
11. Carcello and Nagy (2004) include the first year of the auditor-client relationship in the
SHORT category.
12. Other variables have been shown to affect the bid-ask spread including number of
competing dealers (Tinic and West, 1972) and institutional holdings (Muller and Riedl,
2002). These data are not readily available and are not included in our study.
13. Compustat data beginning in 1950 was used to calculate FIRMAGE.
14. The mean annual SPREAD from 1992 to 2001 is 5.14, 4.66, 4.49, 4.00, 4.13, 2.79, 3.46,
3.03, 2.99, and 1.67, respectively. We do not report those fixed effects in regression tables.
15. Companies in our sample are audited by Arthur Andersen LLP, Coopers & Lybrand LLP,
Deloitte & Touche LLP, Ernst&Young LLP, KPMG Peat Marwick LLP, or Price
Waterhouse LLP. In addition, companies in our sample may have been audited by
PriceWaterhouse Coopers LLP, the firm created by the merger between Coopers & Lybrand
LLP and Price Waterhouse LLP in 1998.
16. In addition we delete firms whose stock price is less than $1 and we also delete Berkshire
Hathaway Inc. whose stock price exceeded $50,000 during our sample period.
17. The coefficients for each year from 1992 to 2000 are, respectively, 2.77, 2.47, 2.55, 2.20, Auditor tenure,
2.25, 1.22, 1.32, 0.68, and 0.53 for Table V, Panel A column (a). Results for fixed effect in
other columns are almost identical. specialization
18. MEDIUM is not represented in the model as it is the benchmark group. and asymmetry
19. To determine this we made LONG our benchmark group by removing LONG and including
MEDIUM in the model. SHORT was significantly smaller than LONG.
20. To make this determination, we included indicator variables for each tenure year, except the
first year thus allowing first year engagement auditors to be the benchmark.
621
21. We do not examine the reason for the change (resignation or dismissal) or nature of the
change (switch from (to) specialist).
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Corresponding author
Kimberly A. Dunn can be contacted at: kdunn@fau.edu
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Managerial Auditing Journal

Auditor tenure, auditor specialization, and information

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production among investors.

Audits, auditor industry specialization, and audit quality

Audit firm tenure and audit quality

H2. The level of information asymmetry as measured by the bid-ask spread

Specialization and tenure interaction effects

III. Research design

measure of cross-sectional differences in the level of information asymmetry

SPREAD ¼ V0 þ V1TURNOVER þ V2VOLATILITY þ V3MKTVAL

þ V16SPECI þ V17CHANGE þ V18SHORT þ V19LONG þ 1

SPREAD ¼ b0 þ b1TURNOVER þ b2VOLATILITY þ b3MKTVAL

portfolio share, or composite measure as defined in the section

SHORT – is equal to 1 if 2 # TENURE # 3, and 0 otherwise.

IV. Empirical results

28 Chemicals and allied products 2,551

LONG 31,689 0.215 0 0 0

AGE ? 0.017 (,0.001) 0.018 (,0.001) 0.018 (,0.001)

AGE ? 0.0171 (,0.001) 0.019 (,0.001) 0.018 (,0.001)

Robustness tests to control for biases in specialization measures

V. Summary and conclusions

of auditor-client relationships on the level of information asymmetry. Second, regulators

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Management 18:1, 5-18. [Abstract] [Full Text] [PDF]

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