THE EFFECT OF MANDATORY PARTNER ROTATION ON AUDIT QUALITY

ABSTRACT. The theory that I shall seek to elaborate here puts considerable emphasis on possible consequences of mandatory auditor rotation, the effect of auditor tenure on audit quality, and the pros and cons of mandatory rotation. Related topics I will explore include mechanisms that facilitate audit partner rotation, the consequences of mandatory partner rotation, and the impact of mandatory partner rotation on audit quality.JEL Codes: H83; M4Keywords: audit partner rotation; mandatory; quality; firm1. IntroductionI am specifically interested in how previous research investigated the potential erosion of client-specific and industry knowledge resulting from mandatory audit partner rotation, the desirability of mandatory rotation, and the association between earnings quality and auditor rotation. The mainstay of the paper is formed by an analysis of the association between both audit firm and partner tenure and audit quality, the consequences of mandatory audit firm rotation, the potential benefits of audit firm rotation using mandatory rotators data, and mandatory rotation as a way to promote a more independent auditorclient relationship.2. Mechanisms that Facilitate Audit Partner RotationHolding audit quality constant, mandatory rotation does not directly affect the quality of the client's pre-audit financial statements. A change of partner may worsen audit quality (partners may gain more knowledge from longer tenure with the client), whereas a change of audit partner may improve audit quality by bringing a fresh perspective to an audit. Mandatory rotation can improve audit quality in the year before rotation occurs and in the year of appointment of the new partner. Audit reports in China (Popescu, 2013d) disclose the names of the engagement and review partners. The review partner and the engagement partner share the same legal liability (unless there is contrary evidence) and are subject to the same rules on mandatory rotation (audit firms in China are allowed to organize as limited liability companies or as partnerships). The rules in China allow for simultaneous rotation of both the engagement partner and the review partner. Auditors are required to judge whether a misstatement is material by considering both its quantitative magnitude and any relevant qualitative factors. Audit adjustments occur more often when the engagement partner is scheduled for mandatory rotation at the end of the year, and during the incoming partner's first year of tenure than in other years. A newly appointed partner is more likely to detect and correct financial reporting problems (Popescu, 2013c) during his first year of tenure. Mandatory partner rotation has a beneficial effect in the final year of tenure before rotation occurs and in the subsequent year when the new partner is appointed. The higher frequency of audit adjustments surrounding partner rotation is not attributable to differences of judgment between the departing partner and the new partner. Mandatory partner rotation has a beneficial impact on audit quality even in the absence of mandatory audit firm rotation, can have a positive impact on audit quality, and significantly increases the frequency of audit adjustments. The positive association between audit firm tenure and audit quality can reflect the underlying factors that cause voluntary switches. (Lennox, Wu, and Zhang, 2014)Increased client-specific knowledge provides a comparative advantage in detecting material misstatements in financial reports. Individual auditors store information about the client in memory and the audit firm stores information about the client in audit work papers. The CLERP 9 regulatory changes on mandatory audit partner rotation have been effective in improving audit quality. Auditors tend to issue going-concern opinions for financially distressed companies (Nicolaescu, 2012) when audit partner tenure is equal to or more than the mandated period. There is a significant and positive association between long audit partner tenure and the likelihood of issuing a goingconcern opinion for a financially distressed company. …