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    Audit Partner Rotation and Financial Reporting Quality
    research summary posted February 15, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 11.0 Audit Quality and Quality Control, 11.01 Supervision and Review – Effectiveness 
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    Title:
    Audit Partner Rotation and Financial Reporting Quality
    Practical Implications:

    This study informs the debates on costs and benefits of audit partner rotation. The results support concerns of the audit profession that audit partner rotation may impair the quality of audited financial information in the initial years of a new partner’s engagement with a client. This impairment appears to be more pronounced for larger clients and clients of non-Big 4 audit firms. Furthermore, the persistence of these quality consequences for non-Big 4 audit firms raises questions about the resource capacity of such firms to cope with imposing regulations. Given that partner rotation has both monetary and social costs, perhaps the decision to shorten partner engagement with a client from seven to five years is not in the best interests of auditors and investors. Ultimately, the costs of an audit will be passed onto investors, and as the study suggests, more frequent rotation may mean more periods of lower financial statement quality in the initial years of a partner’s engagement with a client. Additionally, the study’s city-level industry specialist and office size results suggest industry specialists and larger audit firm offices may have more capacity to absorb and manage partner rotation effects than non-specialists and smaller offices. Such findings support the audit profession’s concern over resource challenges brought on by more stringent partner rotation requirements. 

    For more information on this study, please contact Paul Tanyi.

    Citation:

    Litt, B., D. S. Sharma, T. Simpson and P. N. Tanyi. 2014. Audit Partner Rotation and Financial Reporting Quality. Auditing: A Journal of Practice and Theory 33 (3): 59-86

    Keywords:
    Audit quality, earnings management, financial reporting quality, discretionary accruals, meet or beat, partner rotation, partner change
    Purpose of the Study:

    Audit partner rotation has received considerable attention globally and in the U.S. since Section 203 of the Sarbanes-Oxley Act of 2002 accelerated the rotation period for lead and concurring engagement partners from seven to five years and expanded their cooling-off period from two to five years. Policymakers have rationalized these regulations based on enhanced partner independence and a fresh set of eyes examining the financial statements, thus increasing overall audit quality. However, the audit profession has argued that the loss of engagement partner continuity and client-specific knowledge brought on by increased rotation may actually hinder the quality of the audit. Despite such debate, there is a paucity of research on the effects of audit partner rotation in the U.S., largely due to the absence of publicly available information on audit partners. Using a novel approach to determine audit partner rotation, the authors are able to investigate the effect of rotation on financial reporting quality in the U.S. 

    Design/Method/ Approach:

    After performing procedures to obtain assurance on audit firm compliance with rotation regulations, the authors collect data from 2000 to 2010 for a sample of U.S. public clients that have changed audit firms. From this data, they are able to determine: (1) the first year of a partner’s engagement with a client (the year of audit firm change), (2) the year of audit partner rotation (five years later), and (3) the post-rotation year that a new audit partner leads the audit engagement (the sixth year post-audit firm change). The authors then examine whether financial reporting quality differs between the final two years with an outgoing partner and the first two years with a new partner post-rotation by evaluating discretionary accruals and going-concern reporting for these periods.

    Findings:
    • The authors find that financial reporting quality is lower during the first two years with a new audit partner as compared to the last two years with an outgoing partner. 
    • The authors find that partner rotation has a more adverse effect on financial reporting quality for larger clients of Big 4 auditors and across all clients of non-Big 4 auditors. 
    • The authors find the decline in financial reporting quality to be limited to the first year post-rotation for larger Big 4 clients, but persistent for up to three years post-rotation for non-Big 4 clients.
    • The authors find that non-specialist audit firms and audit firms with smaller offices at the city-level exhibit lower financial reporting quality as a result of rotation.
    • The authors find that financial reporting quality is less negatively affected during the first two years of an audit partner’s engagement with a client relative to the first two years of an audit firm’s engagement with a client.
    Category:
    Audit Quality & Quality Control, Standard Setting
    Sub-category:
    Impact of SOX, Supervision & Review – Effectiveness