How Do Various Forms of Auditor Rotation Affect Audit Quality? Evidence from China

The Enron/Arthur Andersen scandal has raised concerns internationally about auditor independence, audit quality, and the need for regulatory action such as mandatory auditor rotation. China's unique institutional features provide a setting in which we can compare comprehensively the various forms of auditor rotation at different levels (partner vs. firm) and in different settings (voluntary vs. mandatory). In addition, institutional conditions vary dramatically across China, which provides us with an opportunity to test whether the development of market and legal institutions affects the impact of rotation on audit quality. We expect that auditors are less (more) constrained by market forces and less (more) self-disciplined to maintain audit quality in regions with less (more) developed market and legal institutions. Therefore, mandatory rotation may play a more (less) important role in less (more) developed regions. Using auditors' propensity to issue a modified audit opinion (MAO) as a proxy for audit quality, we find that firms with mandatory audit partner rotations are associated with a significantly higher likelihood of an MAO than are no-rotation firms. However, this effect is restricted to firms located in less developed regions. We find similar evidence for voluntary audit firm rotation although the significance level is much weaker than for mandatory partner rotation. Other forms of auditor rotations (i.e., mandatory audit firm rotation and voluntary audit partner rotation), have no effect on MAOs.     

Regulating the Market for Audit Services: A Game Theoretic Approach

We apply game theory to model how alternative mandatory audit firm rotation regimes can affect the strategic interaction between auditee and auditor firms, and analyze potential consequences on detection risk and impairment of auditor scepticism. The major results suggest that: (1) relative to an initial state with no rotation requirement but high probability for impaired auditor scepticism, imposing either short-term or long-term mandatory audit firm rotation will remove the threat to auditor scepticism and lead to higher audit fees and lower detection risk; (2) relative to long-term mandatory audit firm rotation, imposing a short-term rotation will lead to lower audit fees and higher detection risk, resulting from greater informational frictions. We further find that imposing supplementary regulatory instruments, such as increased regulatory scrutiny of the auditee and/or auditor, can be used to lower the detection risk and increase audit quality. We discuss implications of these findings for empirical research.     

Can the academic literature contribute to the debate over mandatory audit firm rotation?

Recently, the Public Company Accounting Oversight Board (PCAOB) issued a concept release soliciting public recommendations to improve auditor independence and audit quality (PCAOB, 2011). The focus of the release is on mandatory audit firm rotation (MAFR) with a request for commentaries addressing the advantages and disadvantages of MAFR. In this paper, we briefly summarize the recent literature on mandatory audit firm rotation and suggest how it can be useful to regulators as they consider the implementation of mandatory rotation. We find that the conclusions reached about the possible effectiveness of MAFR appear to depend on the type of data used (voluntary vs. mandatory auditor changes), suggesting that regulators should exercise care when drawing inferences from past audit firm rotation research.     

Conservative Reporting and the Incremental Effect of Mandatory Audit Firm Rotation Policy: A Comparative Analysis of Audit Partner Rotation vs Audit Firm Rotation in South Korea

In this paper, we take advantage of Korea's unique experiment with mandatory audit firm rotation (MAFR) and mandatory audit partner rotation (MAPR) to ascertain their influence on audit quality, proxied by conditional conservatism. Overall, we find that the implementation of MAFR did not have the desired effect. Firms that adopted MAFR demonstrate higher levels of conservatism in previous periods under MAPR (or compared to voluntary adopters). Furthermore, we find that audit tenure increases conservatism levels consistent with the auditor expertise hypothesis. However, whilst evidence suggests MAFR decreases audit quality on the whole, we find that firms that switch from non‐Big 4 to Big 4 auditors demonstrate higher conservatism because Big 4 auditors are more likely to demand conservative accounting practices, consistent with Big 4 audit firm knowledge superiority. Overall, the results suggest that MAFR's negative effect on audit quality can be mitigated by Big 4 auditor supervision.     

Audit Firm Tenure and Audit Quality in a Constrained Market

We examine the relation between audit quality and audit firm tenure in the Iranian audit market, which is constrained by government policies that create intense competition for clients among many small audit firms. We develop arguments that these circumstances create cost pressures that entrench low audit quality and render auditors' plans more predictable to managers wishing to misstate their accounts. Using publicly available data for the audits of listed companies in Iran prior to mandatory audit firm rotation and the incidence of misstated financial reports identified by the Iranian Association of Certified Public Accountants Inspection Office, we find that the likelihood of a misstatement is lowest in the first two years of audit firm tenure. We also find that the likelihood of misstatement is not associated with the year preceding a mandatory audit firm rotation, suggesting outgoing auditor effort is not sensitive to the prospect of subsequent revelations of deficiencies. Although our results from a pre-mandatory rotation period show that frequent rotations appear to improve the financial reporting quality in our sample, we are wary of interpreting these results as support for the mandatory audit firm rotation policy in Iran. Rather, we suggest this is a peculiar consequence of deficiencies in audit quality inherent in the Iranian market.     

The impact of auditor rotation on auditor–client negotiation

This paper reports the results of an experiment designed to investigate how mandatory audit firm rotation affects auditor–client negotiations. Drawing upon process theories of negotiation, we examine the strategies used by auditors and clients as well as the outcomes of their negotiations in alternative settings in which mandatory rotation is imposed or is not imposed. We posit that mandatory rotation changes (1) the dynamics of the audit market by increasing the number of clients who are in the market for a new auditor, and (2) the political costs to a client who switches auditors. These changes, in turn, alter the willingness of the auditor and the client to cooperate during negotiation. The results suggest that with mandatory rotation auditors adopt less cooperative negotiation strategies, producing asset values that are more in line with the auditor’s preferences than with the client’s preferences and more negotiation impasses.     

审计师变更与审计质量:一个理论分析

本文通过建立股东、管理层和审计师三方参与的两委托人-单代理人博弈模型,研究了固定审计费用下不同审计师变更方式对审计质量的影响。研究结果表明,审计师强制性单期变更与审计师强制性定期变更下,审计师与管理层之间的合谋将导致严重的财务舞弊;而在审计师自愿性变更下,股东可以利用解聘现任审计师这一威胁来阻止审计师和管理层之间的合谋,使得审计师和管理层的最优策略均为真实披露公司的盈余信息,并发表标准无保留审计意见。     

Does Opinion Shopping Impair Auditor Independence and Audit Quality?

This study investigates how companies' threats to dismiss auditors and their engagement in opinion shopping influence auditor independence and audit quality, which in turn affect misstatements in financial statements. It also examines how outsiders' reactions to auditor switching influence opinion shopping. The results indicate that neither the predecessor auditor's nor the successor auditor's independence is compromised by dismissal threats and opinion shopping. Further, the successor auditor's audit quality exceeds the predecessor auditor's audit quality. In addition, auditor switching decreases potential understatements and increases potential overstatements in financial statements, and the capital market's and the successor auditor's reactions to auditor switching reduce the benefits of opinion shopping to companies. Additionally, the study sheds some light on the potential effects of both the Sarbanes‐Oxley's restriction on non‐audit services and mandatory auditor rotation or retention. The paper also derives a rich set of empirical implications.     

EC Green Paper Proposals and Audit Quality

In order to restore confidence in financial statements the European Commission proposes different measures to enhance audit quality. This paper examines potential effects of selected proposals on audit quality in the light of prior research findings. It concludes that an increased emphasis on substantive audit procedures may not be beneficial and that joint audits potentially improve competition and audit quality, but might increase audit fees. An appointment by a third party would strengthen auditor independence. The overall impact of a mandatory rotation of audit firms is unclear due to opposite effects on auditor competence and auditor independence. The provision of non-audit services might affect independence in appearance negatively. However, a total ban would not be necessary. Finally, a limit to the proportion of fees an audit firm can receive from a single client as well as a capping of non-audit fees seem to be desirable.     

The association between employee stock option disclosures and corporate governance: Evidence from an enhanced disclosure regime

This study examines the role of corporate governance in employee stock option (ESO) disclosures following the revision of AASB 1028 Employee Benefits in 2001. We find that, while firms do not fully comply with AASB 1028 ESO disclosures, they voluntarily provide other ESO disclosures. In relation to corporate governance measures that have a role in the financial reporting process, we find two corporate governance measures dominate our results—the quality of auditor and duality of the role of CEO and Chair of the Board of Directors. We show that, in general, external auditor quality has positive incremental association with both mandatory and voluntary ESO disclosures while the dual role of CEO and chairperson of the board is associated with lower levels of mandatory disclosure.     

Auditor rotation and the appearance of independence: Evidence from non-professional investors

We examine the impact of audit firm versus partner rotation on non-professional investors’ independence-related perceptions, extending prior research on auditor rotation and independence in fact. Arguments for mandatory audit firm rotation continue to be made by regulators and investor groups based, in part, on the idea that firm rotation will incrementally strengthen independence in appearance relative to audit partner rotation. We report the results of two experiments. The first examines 5-year audit firm versus partner rotation under relatively weak or strong audit committees. We find no statistically significant difference in beliefs about how much of an income reducing audit difference management will record, or in beliefs about auditor independence, between the two auditor rotation conditions. On the other hand, we find that non-professional investors do believe more of the audit difference will be recorded, and the auditors will be more independent, under a strong audit committee than a relatively weak audit committee. The second experiment provides further evidence on audit firm versus partner rotation by examining a setting involving a 26-year audit firm–client relationship. Again, no statistically significant differences between the two auditor rotation conditions were found. These findings suggest that compared to audit partner rotation, audit firm rotation does not strengthen independence in appearance among non-professional investors and that non-professional investors recognize the value of strong audit committees.     

Some Economics of Audit Market Reform

The purpose of audit market reforms since 2001 is to restore public confidence in the institution of auditing based on two considerations: (1) ensuring audit quality; and (2) controlling the ‘adverse effect of competition’ in audit supply. Market reforms for audit quality are delivered through a package of prescribed actions motivated by an analytical relationship between audit quality and its possible determinants: (1) limiting audit tenure through a combination of mandatory firm rotation, partner rotation and re‐tendering; (2) limiting provision of non‐audit services (NAS) by the incumbent auditor; and (3) joint auditing and empowering the audit committee to enhance audit quality. This paper examines the competing independence hypothesis and expertise hypothesis that produce ambiguous theoretical relationships for audit quality–audit tenure and the independence‐provision of NAS. We then review whether the empirical literature resolves these conundrums. We also review the usefulness of joint auditing and empowering the audit committee to improve audit quality in the context of audit market reform.     

Mandatory audit firm rotation: Fresh look versus poor knowledge

Our aim in this paper is to investigate the effects of mandatory audit firm rotation (MAR) on companies’ investment decision and auditor choice in a capital market setting. We compare a MAR regime with a non-MAR regime in a setting in which auditors’ independence and companies’ opinion shopping are real concerns. To capture auditor independence and opinion shopping, we model auditor biases (a conservative bias or an aggressive bias) and client firms’ incentives to engage auditors with desired biases. We find that when firms engage in opinion shopping, MAR improves investment efficiency for some firms but impairs investment efficiency for other firms. More generally, we contribute to the literature by demonstrating the real effects of auditing on corporate resource allocation decisions.     

Auditor objectivity as a function of auditor negotiation self-efficacy beliefs

This study empirically examines whether an auditor's perceived ability to negotiate discretionary accounting issues with clients (auditor negotiation self-efficacy) is related to auditor objectivity, and whether an auditor's negotiation self-efficacy has a greater impact on her objectivity when the auditor's accuracy motive (professional identity) is strong rather than weak. We tested the hypotheses using a cross-sectional survey design and obtained 146 responses from among 800 surveyed experienced Swedish auditors. The findings indicate that auditors with higher negotiation self-efficacy were more likely to make decisions on a material and discretionary accounting issue contrary to their clients' desires compared to auditors with lower self-efficacy. The relationship between negotiation self-efficacy and auditor objectivity was not moderated by professional-identity strength. These research findings suggest that recruiting and training auditors to increase their negotiation self-efficacy may be an effective method to enhance auditor objectivity without the problems inherent in other methods, such as auditor rotation. Our sample was obtained in Sweden, which allows long auditor tenures. We caution that, although our analysis controlled for auditor tenure, the effect of auditor negotiation self-efficacy may not be generalizable to countries that limit tenure through regulation.     

New Auditors’ Decisions for Released Firms from the Mandatory Auditor Designation Rule: Evidence From South Korea

This study examines the effect of the mandatory designation rule on audit fees charged and audit hours rendered by auditors for firms released from the mandatory auditor designation rule in the Korean audit market. Under the mandatory auditor designation rule, which took effect in 1991, problematic firms are assigned new auditors by the Financial Supervisory Service. Previous studies suggest that this regulation positively affects the quality of audits by promoting auditor independence. Thus, this study hypothesises that firms that have been subjected to mandatory auditor designation improve the quality of their financial reporting, and that auditors hired after the mandatory designation period account for reduced audit risks when determining audit fees and audit hours. This study shows that audit fees and audit hours of firms released from the mandatory auditor designation rule are lower than those of other initial audit engagements. Taken together, this study's findings reinforce the notion that auditors’ perceptions of changes in audit risk yield corresponding changes in the audit fees they charge and audit hours they render.     

会计师事务所行业专长与审计质量相关性的检验——来自中国上市公司审计市场的经验证据

行业专长是审计师专业技能的重要构成要素之一。国外大量的研究均证实会计师事务所的行业专长能够提高审计质量,而本文的研究却发现,在中国上市公司审计市场中,就总体而言,会计师事务所行业专长与审计质量负相关。进一步的分析则表明,目前我国会计师事务所总体上独立性相对不高、易受行业内经济依赖度的负面影响和行业专长发展程度较低是造成这种负相关性的主要原因。     

The influence of jurors' perceptions of auditor tenure on blame

This study investigates whether jurors' judgments of auditor blameworthiness are influenced by the length of an auditor's tenure with a client. We use an experiment to determine whether tenure affects juror perceptions of an auditor's competence and independence. We then examine whether these perceptions influence the attribution of blame. Results, consistent with both sides of the mandatory auditor rotation debate, indicate that tenure has a positive impact on perceptions of competence and a negative impact on perceptions of independence. Further, as juror perceptions of the auditor's competence and independence decrease, attributions of blame increase. These results have implications for auditor tenure research as well as for auditors involved in litigation. By utilizing structural equation analysis, we find that the effects of auditor tenure on perceptions of audit quality are complex. Perceptions of both competence and independence are significantly related to extended tenure; however, these perceptions independently affect the assignment of blame. While longer tenure improves perceptions of competence and lessens blame, it decreases perceptions of independence resulting in greater blame. From a litigation perspective, the auditor's tenure with a client is a double-edged sword that must be addressed strategically in court.     

A test of the auditor reliability framework using lenders’ judgments

Taylor et al. (2003) challenged the longstanding notion that independence is the capstone of the audit profession by proposing a conceptual framework that emphasizes reliability, rather than independence, as the professional endgame for auditors. Although the reliability framework has attracted attention from policymakers, it has not been tested empirically in an audit context to assess its validity from a user’s perspective. The objective of this study is to test the auditor reliability framework and its formative ethical constructs (i.e., integrity, expertise, independence, objectivity, and reliability) with a sample of 168 commercial lenders. We also extend the reliability framework to examine the extent that perceived auditor reliability affects lenders’ judgments of financial reporting reliability and default risk in a hypothetical lending scenario. Finally, we evaluate the extent that lenders’ judgments are affected by auditor provision of nonaudit bookkeeping and payroll services to a prospective borrower in violation of current independence rules. The results provide strong empirical support for the relations predicted in the reliability framework. Structural equation model results indicate that auditor integrity is the foundation of the framework, directly affecting lenders’ assessments of auditor expertise, independence, objectivity, and reliability. Further, although integrity and objectivity directly affect perceived auditor reliability, independence and expertise only affects reliability indirectly through its impact on objectivity. Finally, we find that lenders perceive no decrease in auditor objectivity or reliability when existing independence rules are violated by combining audit services with nonaudit services for prospective borrowers.     

Economic analysis of accountants' ethical standards: The case of audit opinion shopping

The public accounting profession presently employs a strict system of ethical standards that relies upon explicit rules plus monitoring and enforcement procedures that penalize violations of the rules. An alternative approach to ethical standards that the public accounting profession may wish to consider is a laissez faire approach. Instead of rules and penalties to enforce desired behaviors, the laissez faire approach utilizes moral training and leadership to motivate professional accountants to act in the public interest, for the sake of the profession as a whole. The theoretical basis for the laissez faire approach is a growing body of evidence in economics and related disciplines that people often take actions to further the collective welfare of a group despite a detrimental effect on their own selfish interests. This paper offers a framework for examining the relative economic merits of the strict and laissez faire approaches to ethical standards within the accounting profession. The framework is based on game theory, and the setting employed in the paper involves opinion shopping by audit clients. The paper finds that the effectiveness of a laissez faire approach to ethical standards, at least in the opinion-shopping scenario, is related to (a) the ethical climate, which refers to the likelihood a given independent auditor will choose the ethical action, (b) the frequency of independent auditor rotation, which reduces the economic advantage of being the incumbent auditor, (c) the explicitness of Generally Accepted Accounting Principles (GAAP), which reduces uncertainty over whether or not a particular act is ethical, (d) the availability of opportunities to discuss ethical choices with rival auditors, and (e) disclosure requirements associated with auditor–client disputes over material accounting issues.     

The effect of mandatory auditor assignment and non-audit service on audit fees: Evidence from Korea

In Korea, regulators could assign auditors to firms. We investigate the relationship among audit fees, mandatory auditor assignment, and the joint provision of non-audit and auditor services in Korea. We find that assigned auditors charge significantly higher audit fees than freely selected auditors. We also find that the joint provision of non-audit and audit services does intensify the relation between auditor assignment and audit fees. Combined with the results of other studies that have shown that firms audited by assigned auditors report smaller amounts of discretionary accruals than firms audited by freely selected auditors, our results suggest the possibility that mandatory auditor assignment may improve auditor independence.