Mandatory audit firm rotation

Starting from June 17, 2016, European Union-listed companies, banks, and insurance companies are required to change auditor firms after 10 years. This period can be extended to 20 years if the audit is put out for bid, or 24 years in instances of joint audits. Mandatory audit firm rotation has been on the PCAOB’s agenda for a while. In 2011, the PCAOB issued a concept release on auditor independence and audit firm rotation and requested public comments on this release. However, the PCAOB abandoned this project in 2014, after only a three-year pursuit.

It has been argued that long-term auditor—client relationships can result in auditors becoming complacent and lax in their attestation roles. Lack of auditor independence from the client firm is also a matter of concern. One suggested avenue to address these concerns is to place term limits by enforcing mandator}' audit firm rotation (MAR). Opponents of MAR argue that a new auditor will not have the benefit of client-specific knowledge of a previous auditor (General Account Office 2003). This poor knowledge of the new auditor hampers the effectiveness of the audit process and can result in a deadweight loss to society. On the other hand, proponents of MAR claim that a new auditor would bring a fresh look to the auditing task, and that it is an effective way of ensuring auditor independence and preventing “opinion shopping.”

Theoretical research has provided mixed predictions on the effect of mandator}’ rotation on audit quality. Beck and Wu (2006) suggest that mandatory rotation destroys clientspecific knowledge gained from long auditor—client tenure, and allows “opinion shopping” under the guise of moving to a more independent auditor. Ronen and Ye (2019) suggest that although mandator}' firm rotation will strengthen incumbent audit firm independence, the replacement firm is likely to be not as diligent as the incumbent. This is because the new audit firm does not have a technological advantage compared to the incumbent audit firm. Lu and Sivaramakrishnan (2009) analyze the effect of mandator}' rotation on companies’ investment decisions. They demonstrate that when firms engage in opinion shopping, mandatory rotation improves investment efficiency for firms with bad prospects but impairs investment efficiency for firms with good prospects. Bleibtreu and Stefani (2018) extend the market matching model of Salop (1979) to an audit market and show that client importance and audit market concentration are in direct conflict.

Patterson et al. (2019) show that audit tenure reduces fraud. Dordzhieva (2018) demonstrates conditions under which mandatory rotation could actually impair auditor independence.

The majority of empirical research did not find supporting evidence on mandatory audit firm rotation. For example, Gerakos and Syverson (2015) estimate that, for U.S. publicly traded firms, mandatory' audit firm rotation would induce consumer surplus losses of approximately $2.7 billion if rotation were required after 10 years and $4.7—5.0 billion if after only four years. Kwon et al. (2014) find that mandatory audit firm rotation in South Korea introduced higher audit fees, though audit quality (measured as abnormal discretionary accruals) was not improved. Reid and Carcello (2017) show that investors react negatively to events that increased the likelihood of rotation in the U.S. In contrast, Cameran et al. (2016) find that the auditor becomes more conservative in the last three-year period preceding the mandatory rotation in Italy. This suggests that mandatory audit firm rotation has an effect on the auditor’s reporting decision.

Rather than mandatory' firm rotation, many jurisdictions enforce mandatory' audit partner rotation, such as Argentina, Australia, Belgium, China, Denmark, France, Germany, Mexico, The Netherlands, New Zealand, Norway, Russia, the United Kingdom, and the United States.

The effect of mandatory' partner rotation on audit quality' is not obvious. On one hand, a change of partner may' worsen audit quality because of the loss of partners who have gained more knowledge from longer tenure with their clients. Rotation may result in the incoming partner being less well informed about the client and, therefore, less likely to identify a financial reporting problem. On the other hand, a change of audit partner may' improve audit quality by bringing a fresh perspective. It has been argued that a change of partner can provide a powerful peer review effect because the incoming partner assesses the work carried out by the departing partner in the previous year. This can motivate the departing partner to conduct a higher-quality audit before the engagement is handed over to the new partner. Accordingly, mandatory rotation can improve audit quality in the year before rotation and in the year that the new partner is appointed.

Research findings on the effect of audit partner rotation are mixed. Using abnormal accruals and earnings response coefficients as proxies for audit quality, Chi et al. (2009) do not find audit quality improvements in Taiwan due to mandatory partner rotation. Daugherty et al. (2012) use structured interviews and surveys of practicing audit partners to examine the effect of partner rotation on audit quality. Their results suggest that audit quality actually suffers. However, Lennox et al. (2014) show that mandatory' partner rotation has a beneficial effect (i.e., more audit adjustments) in the partner’s final year of tenure before rotation occurs and in the subsequent year when the new partner is appointed in China. These research uses different methods and data from different countries and reached different conclusions. Thus, we do not draw a definite conclusion regarding the effect of such a policy.