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    Does Mandatory Rotation of Audit Partners Improve Audit...
    research summary posted July 16, 2015 by Jennifer M Mueller-Phillips, tagged 11.0 Audit Quality and Quality Control, 15.0 International Matters, 15.01 Audit Partner Identification by Name, 15.03 Audit Partner Rotation 
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    Title:
    Does Mandatory Rotation of Audit Partners Improve Audit Quality?
    Practical Implications:

    The authors contribute to the literature on mandatory partner rotation by showing that it has a beneficial impact on audit quality even in the absence of mandatory audit firm rotation. The findings are important given that many countries currently require partner rotation, but not audit firm rotation. The authors infer how mandatory rotation affects audit quality by examining the impact on audit adjustments. The authors contribute to the existing literature on the determinants of audit adjustments by showing that mandatory partner rotation increases the frequency of adjustments during the partner’s final year of tenure and during the replacement partner’s first year of tenure.

    Citation:

     Lennox, C. S., Wu, X., & Zhang, T. 2014. Does Mandatory Rotation of Audit Partners Improve Audit Quality? Accounting Review 89 (5): 1775-1803.

    Keywords:
    audit adjustment, audit partners, audit quality, mandatory rotation
    Purpose of the Study:

    Many jurisdictions impose limitations on the length of audit partner tenure, but they impose no limitations on the length of audit firm tenure. Despite the widespread prevalence of this practice, there is very little evidence on the consequences of mandatory partner rotation when audit firms do not have to be rotated. This is primarily because most countries do not require partners’ names to be disclosed and so researchers are unable to identify when partner rotation occurs.

    When only the audit partner is rotated and the audit firm remains the same, the audit methodology, procedures, and other engagement personnel do not necessarily change. Therefore, it is an open question whether mandatory partner rotation can really improve audit quality. This question is important because if mandatory partner rotation does not help to improve audit quality, then regulators are likely to call for alternative and more restrictive policies, such as mandatory rotation of the entire audit firm.

    The authors choose China as the empirical setting for two reasons. First, just as in the U.S., in China, the engagement and review partners have to be rotated every five years. Audit reports in China disclose the names of both partners. This allows the authors to identify cases in which one or both of the partners are switched due to the mandatory rotation requirements. Second, since 2006, audit firms in China must report the pre-audit annual profits of all publicly traded clients to the Ministry of Finance. The Ministry provided these proprietary data to the authors for the purposes of academic research.

    Design/Method/ Approach:

    The authors use a logistic model to test their hypotheses. The authors use a final sample of 6,341 company-year observations from the Inspection Bureau’s audit adjustments database for the period 20062010. All the partner rotations in the sample occur on audit firms’ continuing engagements.

    Findings:

    1) Audit adjustments occur more often when the engagement partner is scheduled for mandatory rotation at the end of the year. Consistent with a beneficial peer review effect, this suggests that the departing partner anticipates the arrival of a new partner in year t+1 and this motivates the departing partner to conduct a higher quality audit in year t.

    2) Audit adjustments occur more often during the incoming partner’s first year of tenure than in other years. This is consistent with mandatory rotation generating a fresh perspective, such that a newly appointed partner is more likely to detect and correct financial reporting problems during the first year of tenure.

    Overall, the results suggest that mandatory partner rotation has a beneficial effect in the partner’s final year of tenure before rotation occurs and in the subsequent year when the new partner is appointed. The results are found to be statistically significant for: (1) large and small adjustments, and (2) downward and upward adjustments. The results are statistically significant for engagement partners, but not for review partners, which makes sense given that the engagement partner has a more important role in the audit fieldwork.

    Category:
    Audit Quality & Quality Control, International Matters
    Sub-category:
    Audit Partner Identification by Name, Audit Partner Rotation