Empirical evidence: audit quality under a dual mandatory auditor rotation rule

Posted by ANGELA PETTINICCHIO - Apr 24, 2020
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Regulators in the US ruled against introducing mandatory firm rotations in addition to the existing rule for periodic partner rotations. In contrast, European regulators ruled in favour of a dual mandatory rotation rule in which both audit firm and audit partner rotations are required.
 
But who was right? 
 
It is unclear ex-ante whether requiring two layers of rotation can generate any incremental net benefits over a single rotation rule. Dual rotation may increase the frequency of the fresh-eyes effect, and/or lead to greater criticism by the outgoing auditor, but at the same time may reduce incentives for auditors to invest in acquiring client-specific knowledge relative to a single rotation rule. While the balance of these effects is hard to predict, it is possible it is different under a dual rotation rule than under a single rotation rule. Moreover, because audit partner and firm rotations have been studied separately, one cannot draw safe conclusions from the empirical evidence as to how audit quality would be affected when requiring both rotation types.  
In this paper we explore a unique research setting, i.e. Italy, where mandatory audit firm rotations are required since 1975, and partner mandatory rotations were introduced in 2006, in line with EU regulation. 
Specifically, we analyse several earnings-based measures of audit quality along with the market perception of audit quality to assess the net benefit (cost), of audit firm rotation incrementally to partner rotation. Controlling for partner rotation, we do not find that firm rotations have a positive incremental effect. In contrast, we find audit partner rotation under the dual regime appears to improve both the earnings-based measures of audit quality, and market perceptions of earnings. Our evidence suggests that any benefit arising from dual rotation is likely to be driven by the change in partner. However, whether the audit firm rotation should still be required is unclear, given that the observed benefits arising from the audit partner rotation could potentially be preconditioned on audit firm rotation.
 
Read the full paper couathored with Jo Horton and Gilad Livne at: https://doi.org/10.1080/09638180.2020.1747513
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