The Effects of Mandatory Auditor Rotation on Low Balling Behavior and Auditor Independence
Accounting Oversight Board have suggested the implementation of the external audit firm rotation. The aims of this proposal are to increase auditor independence and to decrease the high level of supplier concentration in the audit market. However, proponents of this regulation raise the concern that learning effects are destroyed, which causes inefficiencies in terms of both audit quality and audit fees. In the present paper, we use a market matching model adopted from Salop (1979) to analyze the effects of the external rotation. In particular, we assume that both industry expertise (i.e., the audit firm's specialization in auditing clients with specific characteristics) and the auditor's experience with a certain client (i.e., learning cost effects) determine an audit firm's direct audit costs. Our model allows determining the optimal matching between audit firms and clients in a situation with and without the existence of the mandatory audit firm rotation rule. Our results indicate that mandatory auditor changes decrease audit firms' profit contributions derived from clients the audit firm is quite well specialized in. The decrease in these profit contributions is particularly severe if learning costs play a dominant role. For clients the audit firm is less specialized in, however, the implementation of the external rotation even increases audit firms’ profit contributions, since it can demand comparably high audit fees when the most efficient audit firm is precluded from auditing these clients due to its cooling-off. (1) If audit firms have strong time preferences, audit firms will choose a lowballing strategy; audit firms may regard the external rotation as favorable only if learning costs are sufficiently low. If, in contrast, learning effects are important, audit firms' total profit contributions decrease, and the equilibrium number of audit firms also decreases. An increase in supplier concentration, however, is clearly in contrast to the aims of the EU Commission. (2) If audit firms apply low discount rates and thus follow a waiting strategy, the external rotation increases audit firms' total profit contributions and indeed decreases supplier concentration. With respect to our audit quality measure, we find that audit firm rotation increases audit quality only if audit firms try to re-acquire their clients as fast as possible, i.e., if they use a lowballing strategy for clients they are not well specialized in (i.e., if the discountrate is high). If, in contrast, audit firms are patient enough to wait until the maximum duration of their competitors has expired, audit quality is predicted to decrease due to the implementation of the external rotation.
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- Steven C. Salop, 1979. "Monopolistic Competition with Outside Goods," Bell Journal of Economics, The RAND Corporation, vol. 10(1), pages 141-156, Spring.
- Sattar A. Mansi & William F. Maxwell & Darius P. Miller, 2004. "Does Auditor Quality and Tenure Matter to Investors? Evidence from the Bond Market," Journal of Accounting Research, Wiley Blackwell, vol. 42(4), pages 755-793, 09.
- Reiner Quick, 2012. "EC Green Paper Proposals and Audit Quality," Accounting in Europe, Taylor & Francis Journals, vol. 9(1), pages 17-38, June.
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- Christopher Humphrey & Asad Kausar & Anne Loft & Margaret Woods, 2011. "Regulating Audit beyond the Crisis: A Critical Discussion of the EU Green Paper," European Accounting Review, Taylor & Francis Journals, vol. 20(3), pages 431-457, June.
- Christopher Bleibtreu & Ulrike Stefani, 2012. "The Interdependence Between Audit Market Structure and the Quality of Financial Reporting: The Case of Non-Audit Services," Working Paper Series of the Department of Economics, University of Konstanz 2012-01, Department of Economics, University of Konstanz.
- Arrunada, Benito & Paz-Ares, Candido, 1997. "Mandatory rotation of company auditors: A critical examination," International Review of Law and Economics, Elsevier, vol. 17(1), pages 31-61, March.
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