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    Are There Adverse Consequences of Mandatory Auditor...
    research summary posted July 27, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 15.0 International Matters, 15.04 Audit Firm Rotation 
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    Title:
    Are There Adverse Consequences of Mandatory Auditor Rotation? Evidence from the Italian Experience.
    Practical Implications:

    The consequences of mandatory rotation appear to be (1) higher audit fees, and (2) lower-quality audited earnings following rotation (which is consistent with the evidence in non-mandatory settings). The authors conclude with some conjectures on how the negative effects of mandatory rotation observed in Italy might be even greater in countries with larger audit markets and larger clients, such as the United States and other European Union countries, which should give regulators pause. Another unintended consequence of mandatory rotation in the United States would be to reduce an audit firm’s industry expertise. A rotation rule in the United States and other large economies could disrupt the market and fundamentally change the way accounting firms are organized for the delivery of audits. 

    Citation:

    Cameran, M., Francis, J. R., Marra, A., & Pettinicchio, A. 2015. Are There Adverse Consequences of Mandatory Auditor Rotation? Evidence from the Italian Experience. Auditing: A Journal of Practice & Theory 34 (1): 1-24.

    Keywords:
    audit fees, audit market regulation, auditor rotation, earning quality
    Purpose of the Study:

    Mandatory auditor rotation was recently proposed for the European Union and is also under consideration in the United States. On April 24, 2013, the Legal Affairs Committee approved a proposal for a 14-year rotation rule. However, the full European Parliament has not yet acted on the recommendation. At the heart of the case for mandatory rotation is the belief that bad things can happen when auditors have long tenure. On the other hand, it may be the case that bad things do happen in the short-tenure setting due to a learning curve effect. Short tenure occurs when there is a change in auditor and there is evidence that earnings quality is lower during the first few engagement years, which is consistent with a learning curve on new audits.

    There has been little research into either the benefits or costs of rotation in a true mandatory setting that could inform intelligent policy making. Given the existing body of evidence, it appears the European Commission is advocating a major change to the audit market that is not supported by extant research. Even worse, the Commission could cause lower quality audits since there would be more frequent auditor changes under a mandatory rotation rule and, therefore, more frequent audits with short tenure and potentially lower quality. This paper helps fill this gap by examining Italy, where mandatory rotation of auditors has been required since 1975, and examines potential negative consequences of mandatory audit firm rotation.

    Design/Method/ Approach:

    The sample is comprised of 204 publicly listed companies in Italy audited by the Big 4 accounting firms over the period 20062009, resulting in 667 firm-year observations in the sample, although the specific sample size varies from test to test depending on data availability. The sample has 52 auditor changes, 36 of which are mandatory rotations (17.6 percent of firms), plus another 16 auditor changes that are voluntary (7.8 percent of firms). 

    Findings:
    • First, for the outgoing auditor, there is no evidence of lower-quality audits due to shirking in the final-year engagement. However, there is some evidence of abnormally higher fees, as the final-year fees are 7 percent higher than normal. This suggests there may some opportunistic pricing, since the authors find no evidence of abnormally higher audit effort in the final-year engagement. The PCAOB report does not identify this as a negative consequence, but the evidence suggests it adds to the cost of mandatory rotation.
    • Second, for the incoming auditor, audit effort (hours) is abnormally higher by 17 percent in the initial engagement, but initial fees are discounted by 16 percent relative to ongoing engagements. However, the authors also find that future audit fees following the first-year audit are abnormally higher by approximately 76 percent of first-year fees.
    • Third, the authors document that earnings quality is lower during the first three engagement years relative to later years of auditor tenure (large abnormal accruals and less timely loss recognition). On average, abnormal accruals are 36 percent larger in the first three years relative to later years of tenure.
    Category:
    Client Acceptance and Continuance, International Matters
    Sub-category:
    Audit Fee Decisions, Audit Firm Rotation