OR Spectrum (2011) 33:265–285 DOI 10.1007/s00291-010-0221-4 REGULAR ARTICLE An overlooked effect of mandatory audit–firm rotation on investigation strategies Wuchun Chi Published online: 1 July 2010 © Springer-Verlag 2010 Abstract Section 207 of the Sarbanes–Oxley Act of 2002 (hereafter, the SOX Act) passed by the US Congress requires a study of mandatory auditor rotation of regis- tered public accounting firms. In the debate over the costs and benefits of mandatory audit–firm rotation, one cost has been overlooked: that of more aggressive monitor- ing. Because few countries have put such mandatory rotation into practice, there is little empirical evidence available for analysis of its costs and benefits. My research, therefore, uses an analytical approach to demonstrate that, in a firm that has a well- functioning independent board, as required by section 301 of the SOX Act, the board will adopt a more aggressive strategy in investigating the collusion between the man- ager and the auditor and pay a higher audit fee than it would have done in an envi- ronment with no audit–firm rotation requirement. The results of this research alter the balance between the costs and benefits of a mandatory audit–firm rotation requirement and should not be ignored by regulators considering implementing such a requirement. Keywords Sarbanes–Oxley Act · Audit–firm rotation · Audit fees · Investigation strategy 1 Introduction Recent scandals involving accounting irregularities have damaged the credibility of accounting audits. In an attempt to help restore this lost credibility, the US Congress passed the Sarbanes–Oxley Act of 2002 (hereafter the SOX Act). Section 203 of this act mandates audit–partner rotation, and section 207 requires a study of mandatory W. Chi ( B ) National Chengchi University, 64, Zhi-nan Road, Section 2, Wenshan, 11623 Taipei, Taiwan, Republic of China e-mail: wchi@nccu.edu.tw 123 266 W. Chi rotation of registered public accounting firms. 1 This research aims to contribute to such study by uncovering and examining an overlooked cost of mandatory audit–firm rotation. Such an examination, if properly conducted, cannot focus solely on section 207 of the act. It must also consider other requirements imposed by this legislation, including higher standards for the makeup and role of the independent audit committee (section 301). Such joint requirements complicate the analysis of any effects of mandatory rotation, for they mandate additional changes to which those effects might also be attributed. Of particular note when considering section 301 is the possibility that man- datory rotation actually hamstrings the board by preventing it from rewarding good audits by retaining a well-performing auditing firm. 2 Another complication of this study is the lack of relevant data. Because few coun- tries have put such mandatory rotation into practice, there is little empirical evidence available for analysis of its costs and benefits. My research, therefore, uses an analyt- ical approach to examine the economic costs of mandatory rotation in a setting that also includes an independent audit board or committee. The traditional view of auditor rotation involves a tradeoff between the benefits and drawbacks of familiarity. This paper does not enter this debate, but rather provides an analysis of certain drawbacks that have gone unnoticed but should be considered in future debates on auditor rotation. One side of the traditional view of rotation holds that familiarity with clients is crucial to produce greater understanding and an improved ability to identify and evaluate risks for clients and that rotation limits an auditor’s ability to develop such an understanding and ability. On the other hand, some auditing professionals also recognize that over-familiarity may be a significant threat to audi- tor independence. The potential impairment of auditor independence constitutes the basic reason for requiring audit–partner and/or audit–firm rotation. In addition, new auditors, an inevitable consequence of auditor rotation, may provide a fresh, unjaded view of the firm during the audit process. The SOX Act reflects these traditional views. Specifically, section 203 of the SOX Act treats audit services as unlawful if the lead or the coordinating audit partner provides services for five consecutive years to a certain client. In addition, section 207 of the SOX Act requires the Comptroller General to conduct a study to exam- ine the potential effects of the mandatory rotation requirement on registered public accounting firms within one year of the passage of the SOX Act. One can say that section 207 suggests that mandatory audit–firm rotation may be an effective means of restoring the credibility of the audit function. This paper examines this suggestion 1 In general, there are two types of auditor rotation: audit–partner rotation and audit–firm r otation. Since the SOX Act has already enforced audit–partner rotation in section 203 but merely calls for the study of audit–firm rotation, this paper focuses on audit–firm rotation. For simplicity, in this article, “mandatory rota- tion” refers to audit–firm rotation rather than to audit–partner rotation. Following the requirements of SOX 207, the Government Accountability Office (formerly the Government Accounting Office) is responsible for studying the effectiveness and implications of audit firm rotation. 2 The idea of mandatory auditor rotation existed prior to recent reforms. In fact, the Report of the Commission on Auditors’ Responsibilities (The Cohen Commission) (1978) recommended mandatory rotation. The Cohen Report reasons that “[s]ince the tenure of the independent auditor would be limited, the auditor’s incentive for resisting pressure from management would be increased” (p. 108). 123 An overlooked effect of mandatory audit–firm rotation 267 by focusing on the economic costs of mandatory audit–firm rotation while taking into account the enhanced role of an independent board (or an independent audit com- mittee), which is required by section 301 of the SOX Act, which addresses board effectiveness. Stressing the idea that the audit committee plays an active role in corporate gov- ernance and acknowledging that there exists a potential for side payments to audi- tors from managers (Lee and Gu 1998), 3 I analytically examine the effectiveness of implementing mandatory audit–firm r otation. Although conventional wisdom sug- gests that requiring mandatory rotation will enhance auditor independence, this study suggests that the mandatory audit–firm rotation requirement is likely to make the audit committee adopt a more aggressive investigation strategy to examine the possi- bility of collusion between the manager and the auditor as well as pay a higher audit fee. Therefore, the mandatory audit–firm rotation requirement creates a cost burden to the firm, namely an extra audit fee payment and a higher monitoring cost due to a more aggressive anti-collusion strategy. The conclusion of this study runs con- trary to the conventional perspective that treats the mandatory rotation requirement as a means to enhance audit effectiveness and, in turn, improve the quality of finan- cial reporting. This conventional perspective ignores the existence of an independent audit committee that is mandated by section 301. Such an independent audit com- mittee represents the interests of shareholders and helps ensure the objectivity of the audit process by decreasing the possibility of collusion between management and auditor—the very possibility that auditor rotation is supposed to guard against. Such a functional redundancy would not necessarily be a drawback of auditor rotation, but in fact this rotation does have a cost: the elimination of an incentive to the auditor. The board can no longer reward good performance—which would include the avoidance of collusion with management—by continuing to hire the auditor, so the incentive for such collusion is actually increased. By failing to consider the role of the board (or audit committee) in providing incentive and reducing collusion, prior literature has assumed that auditor rotation can only increase auditor independence, not decrease it. When we consider the possibility of such a drop in auditor independence, however, 3 Although manager–auditor side payments were generally prohibited even before the SOX Act, Lee and Gu (1998) indicate that side payments could take several forms, some of which were prima facie legal (e.g., the auditor might be appointed by the manager on behalf of the shareholders and the manager could use the appointment itself as a side payment to sway the auditor) and some of which might be legally justified (e.g., granting the auditor with consulting contracts). Generally, preventing or detecting side payments can be legally difficult and expensive. See Footnote 5 (p. 536) of Lee and Gu (1998) for a detailed discussion of potential side payments between the manager and the auditor. The SOX Act of 2002 has added more restrictions on such side payments, prohibiting, for example, most types of consulting and the hiring of former auditors by the audited firms within a year of the audit(United States Code 2002). A public account- ing firm can, however, still perform non-auditing services, such as tax services. Some recent studies provide circumstantial evidence that tax services can be a channel for side payments. Dhaliwa et al. (2004), for example, find that changes in effective tax rates (ETR) between the third and fourth quarters are related to efforts toward earnings management. Omer et al. (2006) further find that one-year-ahead marginal tax rate and ETR reductions are associated with higher tax-service fees paid to the audit firms. Although this evidence is not definitive, it suggests that, despite the provisions of the SOX Act, there may exist channels for managers to deliver side payments to auditors. 123 268 W. Chi the costs of auditor rotation in the context of an independent audit committee become clear. The remainder of the paper is organized as follows. Section 2 reviews the debate on auditor independence, tenure, and mandatory rotation. Section 3 describes the audit pricing model and the investigation strategy of the audit committee in non-rotation-required and rotation-required environments. Section 4 discusses the solution and explains the economic consequences of mandatory rotation. I present concluding remarks in Sect. 5. 2 The debate Since independence is the cornerstone of the auditing function, both legislators and financial statement users are highly concerned with this issue. To reduce the potential threat to auditor independence, proponents of mandatory rotation express the belief that poor quality of financial statements is associated with extended auditor tenure. For example, in July 2003, the International Federation of Accountants (IFAC) issued a report, Rebuilding Public Confidence in Financial Reporting, in which it treats exces- sive familiarity as potentially resulting in auditors’ complacency or hesitancy to chal- lenge appropriately, thereby reducing the level of skepticism necessary for an effective audit (International Federation of Accountants (IFAC) 2003). Louwers (1998) found that the length of the auditor–client relationship affects auditors’ propensity to issue a going-concern disclosure to a distressed client. Hence, proponents of rotation sug- gest that it could significantly improve the overall quality of an audit and enhance the quality of the financial reporting process (e.g., Imhoff 2003; Dopuch et al. 2001). However, the existence of a well-functioning independent board (or an indepen- dent audit committee), such as required by section 301 of the SOX Act, may render those arguments invalid. The independent board or audit committee represents the interests of shareholders, particularly by ensuring the objectivity of the audit process. International Federation of Accountants (IFAC) (2003) also believes that the audit committee needs to interact directly and, at times, forcefully with both management and auditors in areas that in the past have been largely handled outside the commit- tee. 4 In prior literature, discussions on the function of audit committees (e.g., Booth et al. 2002; Klein 2002) and the effectiveness of mandatory rotation (e.g., Arrunada and Paz-Ares 1997; Catanach and Walker 1999; Dopuch et al. 2001) have generally been treated as independent issues. However, the effectiveness of mandatory rotation in improving the quality of financial statements is directly influenced by the func- tion of the audit committee, since this committee is closely involved in the process of preparing these financial statements. Therefore, it is important to include the role 4 The report recommends that each member of an audit committee should be financially literate, and at least one (and preferably a majority) of the committee’s members should have substantial financial expe- rience. The report also recommends that everyone on the audit committee (members and non-members of management alike) should receive training both with respect to their general responsibilities and regarding the operations, business issues, financial reporting, control systems, and risk management processes of the company itself. 123 An overlooked effect of mandatory audit–firm rotation 269 of an effective audit committee in discussing the merits of the mandatory rotation requirement. 5 In a situation where section 301 of the SOX Act is actually enforced, I assume that the possibility that management might threaten the audit firm is eliminated. That is, this paper analyzes the r esult of a theoretical effectiveness of section 301 of the SOX Act and assumes that the concerns over enforcement expressed in the past literature, such as those over managers’ improper influence on auditors due to auditors’ fear of losing clients due to disagreement with managers’ financial reporting preferences (e.g., Farmer et al. 1987). 6 Cautious optimism about the effective enforcement of Sec- tion 301 is justified by recently issued auditing standards that require communication between auditors and audit committees about unrecorded misstatements (SAS No. 89, American Institute of Certified Public Accountants (AICPA) 1999a) and the audi- tor’s judgment about the quality, not just the acceptability, of accounting principles and underlying estimates in the financial statements (SAS No. 90, American Institute of Certified Public Accountants (AICPA) 1999b). Those requirements enhance the importance of the audit committee, giving it a critical role that dominates the role of managers in affecting the outcome of accounting negotiations with the client. In summary, auditor rotation becomes less pivotal in a situation where there exists a well functioning independent board (or independent audit committee) as required by the SOX Act than in a pre-SOX Act environment where auditors can never be completely independent. 7 Opponents of mandatory rotation assert that auditors have to gain experience and build client-specific assets from the ongoing relationship in order to develop a greater ability to detect accounting irregularities (Arrunada and Paz-Ares 1997). Geiger and Raghunandan (2002) have also demonstrated that there are significantly more audit failures in the earlier years of the auditor–client relationship. Some recent empirical studies have investigated the relationship between auditor tenure and discretionary accruals and found that short audit tenure leads to lower audit quality (e.g., Johnson et al. 2002; Myers et al. 2003; Ghosh and Moon 2005; Chen et al. 2008). 8 The evi- dence shows that the mandatory rotation requirement decreases audit effectiveness 5 Members of the board that are independent of management are likely to be more effective in overseeing management than those that are not. This study assumes that there exists a well-functioning independent board or audit committee in the firm. 6 See Bazerman et al. (1997) for a general discussion of the challenges faced by auditors when they know that the client “ may hire and fire auditors at will” (p. 91). 7 This idea is echoed in the following paragraph from the General Accounting Office required study on the potential effects of mandatory audit firm rotation on public accounting firms (US Government Accounting Office 2003): “We also believe that if audit committees regularly evaluated whether audit firm rotation would be beneficial, given the facts and circumstances of their companies’ situation, and are actively involved in helping to ensure auditor independence and audit quality, many of the benefits of audit firm rotation could be realized at the initiative of the audit committees rather than through a mandatory rotation requirement” (p. 9). 8 This approach treats audit quality as a function of earnings quality, which is measured by discretionary accruals. Other proxies for earnings quality include restatements (Stanley and DeZoort 2007, and fraudulent financial reporting ( Carcello and Nagy 2004). In addition, studies investigating the relation between audit firm tenure and perceptions of earnings quality include Mansietal.(2004), who use the cost of debt financ- ing to proxy for creditor perceptions, and Ghosh and Moon (2005), who use earnings response coefficients 123 270 W. Chi and thus lowers the quality of financial reporting. In addition, the National Com- mission on Fraudulent Financial Reporting (The Treadway Commission) (1987) has recommended that the peer review program of the AICPA’s SEC Practice Section pay closer attention to the first-year audits of public clients. This recommendation was made partly because the Commission’s review of fraud-related cases revealed that a significant number of those cases involved companies that had recently changed auditors (p. 54). Further, the Quality Control Inquiry Committee of the AICPA’s SEC Practice Section found that audit failure occurs almost three times as often on first- or second-year audits (American Institute of Certified Public Accountants(AICPA) 1992). In summary, these investigations suggest that mandatory rotation could diminish audit effectiveness and thus lower the quality of financial reporting. In spite of the existing empirical evidence, there are at least two reasons to examine the issue via the analytical approach. First, the results of the empirical studies (e.g. Johnson et al. 2002; Myers et al. 2003; Ghosh and Moon 2005; Chen et al. 2008)were found in a legal environment that did not require audit firm rotation. An analytical analysis can provide supplemental arguments and another perspective to complement prior empirical evidence. Second, audit quality is determined by separate factors: the auditor’s ability to discover errors or breaches, and the degree of independence required to report the errors truthfully (DeAngelo 1981). All existing empirical evidence, how- ever, is based on a joint test of auditors’ independence and ability. To address how mandatory rotation affects auditor independence and audit pricing, I assume that audit effort is unchanged either in a rotation-required or non-rotation-required environment. In the next section, I simplify the model of Lee and Gu (1998) to examine the costs associated with mandatory auditor rotation, particularly monitoring costs and audit fee payments. The focus of the Lee and Gu (1998) study is to examine the relationship between low-balling and auditor independence. They analyze the interaction among the firm owner, the manager, and the auditor, and conclude that low-balling consti- tutes an efficient dynamic contracting mechanism for hierarchal agency. Specifically, they find that low-balling creates a disincentive for unscrupulous audit behavior when the right to hire and fire the auditor lies with the owner. The present paper uses the same framework to analyze the difference in the optimal investigation strategies under rotation-required and non-rotation-required environments where the right to hire and fire the auditor lies in an independent board (or an independent audit committee). 3 The investigation strategies To examine how mandatory rotation affects audit pricing and auditor independence, I analyze the audit fee payments and optimal investigation strategies of the audit committee in non-rotation-required and rotation-required environments, respectively. Because of its focus on the role of the auditor, this paper does not examine alternative footnote 8 continued to proxy for investor perceptions. Regarding the effect of mandatory rotation on audit quality, Chietal. (2009), using evidence from Taiwan, find no evidence that mandatory audit–partner rotation has positive effects on audit quality. Likewise, Ruiz-Barbadillo et al. (2009), using evidence from Spain, come to similar conclusions regarding mandatory audit–firm rotation. 123 An overlooked effect of mandatory audit–firm rotation 271 strategies to induce truthful reporting, such as a contract between the audit committee and the manager, for such a strategy eliminates consideration of the auditor. 3.1 The optimal investigation strategy in a non-rotation-required environment I assume that the audit market is price competitive and that the client’s switching costs and auditor’s start-up costs are non-zero. Following the model from DeAngelo (1981), I calculate the audit fee in a non-rotation-required environment (denoted by NR). Let F 1;NR represent the audit pricing in the initial engagement, and F n;NR = F NR (for n ≥ 2), the audit fee for subsequent periods. Further, there is a constant component to audit cost in each period, A n = A (for n ≥ 2), and a start-up cost, K , in the initial period so that A 1 = A + K represents the initial audit. A client who switches his or her auditor incurs a transaction cost, denoted by S. Finally, r is the discount rate that applies to the auditor’s future profits. Fact 1: In a non-rotation environment: 1. The audit fee on the initial engagement is F ∗ 1;NR = A + K − K+S 1+r , 2. The audit fee on all subsequent audits F ∗ NR = A + r 1+r (K + S), and 3. F ∗ NR − F ∗ 1;NR = S > 0. Proof See DeAngelo (1981) or the brief outline in Appendix 1. Assuming that a firm has a well-functioning audit committee that has the respon- sibility to hire and fire the auditor, I employ the following monitoring and incentive structure, similar to the one used in the Lee and Gu (1998). Particularly, the board employs a manager to handle production and an auditor to verify the reported infor- mation. However, the auditor might accept a side payment B to report with bias in favor of the manager. 9 Because a pure strategy of constantly monitoring an expert and, therefore, relatively efficient auditor removes the advantage of hiring such an auditor, it is too costly for the board to adopt such a pure strategy to always investigate whether there exists collusion between the auditor and the manager. For the same reason, a pure strategy never to investigate is not beneficial for the board either. Accordingly, I assume the board chooses a mixed strategy to scrutinize the collu- sion, with probability π 1;NR in the first period of auditing, and π NR in each subsequent period. Furthermore, if the board investigates and the two agents (i.e., the manager and the auditor) have colluded, the board will discover the misconduct with probability p (where 0 < p < 1). When the two agents behave loyally, there is no evidence that can suggest an allegation of malpractice by the two agents, whether the boards inves- tigates or not. Finally, when the collusion is revealed at a certain time, the auditor pays a one-time legal punishment D and his future income is normalized to zero. 10 In other words, the entire calculation of profit from collusion includes three parts: the periods before collusion is detected, during each of which some profit should be expected; the 9 To focus on the issue of mandatory rotation, I treat the side payment B exogenously for tractability. 10 To examine how mandatory rotation affects the auditor’s independence, I omit the penalty on the manager. 123 272 W. Chi period when collusion is detected, which will result in a penalty; and the periods after collusion has been detected, during which the profit from collusion will be zero. I will start by describing the auditor’s strategy—a pure strategy either of indepen- dence or collusion—in the non-initial period. If the auditor does not collude with the manager, the present value of his total profits is: (F NR − A)(1 + r) r . (1) However, when he colludes with the manager, the auditor receives a payoff B + F NR − A with probability (1 − π NR ) + π NR (1 − p), since the board could either not investigate (with probability 1 − π NR ) or investigate (with probability π NR ) but not discover the misconduct (with probability 1 − p). When the board discovers the collu- sion of the two agents, the auditor pays the fixed court-determined penalty D. 11 Since the auditor has the same optimization problem in each non-initial period, if an auditor’s best choice is to collude in a given period, it is implied that collusion will constitute the best strategy in each subsequent period as well. Consequently, the expected present value of the auditor’s profits from the collusion strategy in a non-initial auditing period is: [ (1 − π NR · p)(B + F NR − A) − π NR · p · D ] ×  1 + 1 − π NR · p 1 + r +  1 − π NR · p 1 + r  2 +···  = [ (1 − π NR · p)(B + F NR − A) − π NR · p · D ] · 1 + r r + π NR · p . (2) The probability factor must be included for each period, because it is only by surviv- ing previous periods (each of which involves its own probability) that an auditor will be able to participate in any following period (each of which, again, involves its own probability). In other words, a particular payoff depends upon an auditor surviving previous periods as well as the current one. Recall that the expected present value of profits for an auditor who chooses an independent strategy is given by Eq. (1). Letting 11 For simplicity, this paper follows Lee and Gu (1998), which treats the court-determined damages as fixed. That is, I omit the potential effect of audit liability regimes (Hillegeist 1999), materiality uncertainty (Patterson and Smith 2003), and inconclusive evidence of fraud (Patterson and Wright 2003). This paper assumes that the auditor cannot receive the net profit, including side payments, of the engagement auditor (B + F NR − A) if he colludes and is discovered. This assumption can simplify the proof, although the major conclusion of this study will be unchanged if D excludes the incurred A, regardless of collusion or its detection. In addition, one may argue that it should include the “fresh view effect” of the successor auditor into the model. In fact, to assess how audit–firm tenure affects audit quality, Myers et al. (2003) examined the relationship between abnormal accruals and audit–firm tenure. They found no evidence that a lengthy audit–firm tenure has a negative effect on audit quality. In fact, their results show that audit–firm tenure enhances, rather than decreases, audit quality, which implies that short audit tenure leads to lower earnings quality because auditing expertise, accumulated by tenure, is important for auditors to detect accounting irregularities. Thus, this paper does not assume any “positive” or “negative” role of the new successor auditor, who might have less client-specific expertise than the predecessor auditor. 123 An overlooked effect of mandatory audit–firm rotation 273 Y denote the result of Eq. (2) subtracted from Eq. (1), we have: Y =  (F NR − A)(1 + r) r  −  [(1 − π NR · p)(B + F NR − A) − π NR · p · D]· 1 + r r + π NR · p  . (3) A positive result for Eq. (3) means that an independent strategy—one free from collusion—is the best course of action for the auditor in a non-initial period. On the other hand, to collude with the manager is the auditor’s rational behavior for a negative Y . Taking the partial derivative of Eq. (3) with respect to F NR − A and B yields: ∂Y ∂(F NR − A) = (1 + r) 2 π NR · p r(r + π NR · p) > 0, and (4) ∂Y ∂ B =− (1 − π NR · p)(1 + r) r + π NR · p < 0. (5) The results show that Y is increasing with the normal audit profit (F NR − A), and decreasing with the level of the side payment. Therefore, either a lower normal engage- ment profit earned by the auditor or a higher side payment afforded by the manager, will induce collusion and threaten auditor independence. Because investigation is costly, the board will choose the lowest π R for which Y is equal to zero. 12 After a simple arrangement, π ∗ NR satisfies the following condition: π ∗ NR = 1 p · B B + 1+r r (F NR − A) + D . (6) Substituting F ∗ NR from Fact 1 into Eq. (6) yields: π ∗ NR = 1 p · B B + K + S + D . (7) Equations (6) and (7) readily show that the higher the probability p or the audit profit during the non-initial periods, F NR − A, the lower the probability that the board will investigate. In addition, the board should adopt a more aggressive investigation strategy (i.e., π ∗ NR increases) when the affordable side payment from the manager increases. Next, I calculate the board’s optimal investigation strategy in the initial period. For a competitive audit market, the profit of an auditor with independence is zero. How- ever, if the auditor compromises his independence then he earns an extra B in period 1 (with probability 1 − π 1;NR · p) or pays punishment D if collusion is detected by the board (with probability π 1;NR · p). Using Eq. (7), which assumes zero profit in 12 In other words, I assume that an auditor who is indifferent between independence and collusion will choose to remain independent. 123 274 W. Chi audit markets, and the backward induction approach, I arrive at the net expected value of profits from the collusion strategy (1 − π 1;NR · p)B − π 1;NR · ( pD). 13 Further, the optimal randomized investigation of the board in the initial period, π ∗ 1;NR ,is: π ∗ 1;NR = B p · (B + D) . (8) Equation (7) subtracted from Eq. (8) yields: π ∗ 1;NR − π ∗ NR = 1 p ·  B · (K + S) (B + D) · (B + K + S + D)  > 0. (9) Equation (9) s hows that the board’s investigation effort is highest in the initial period. Along with Fact 1, which shows that the audit fee increases after the initial period, this equation offers a simplified version of the findings in Lee and Gu (1998). 14 Iuse the results from this section as a benchmark to compare with an environment with mandatory auditor rotation. Proposition 1 For an environment without mandatory rotation: π ∗ 1;NR = 1 p · B B + D , (8) π ∗ NR = 1 p · B B + K + S + D , (7) π ∗ 1;NR − π ∗ NR > 0. (10) Proposition1 expresses the investigation strategies of the independent audit com- mittee in a non-rotation environment in each period in terms of side payments (B), penalties to the auditor for collusion with the manager (D), and the probability of discovery of misconduct (p); for periods after the initial one, the auditor’s set-up costs (K) and the client’s switching costs (S) are added. 3.2 The optimal investigation strategy in a rotation-required environment To analyze how mandatory rotation affects the board’s investigation strategy in each period, I use π n;R (N) to represent the mixed strategy in period n (1 ≤ n ≤ N), where 13 Ideally, this formula should be expressed as (1 − p·π 1;NR )· (B+ Present Value of an Audit Engagement in an Initial Year) −π 1;NR · (pD). However, assuming a zero-profit audit market, the term Present Value of an Audit Engagement in an Initial Year, reduces to zero. 14 The fact that the fee in the initial period is lower than in subsequent periods is what is commonly referred to as “low-balling” or “low introductory pricing.” As compared to legal enforcement and investigation strat- egy , Lee and Gu (1998) explain that low-balling itself is an economical mechanism to self-fulfilled auditor independence. In Sect. 3.2, I will show that mandatory rotation interferes with this mechanism. 123 [...]... rotation- required environments with a shorter and a longer period of rotation, and the thin line portrays the fee in a non -rotation- required environment Although the cost advantage of the incumbent auditors allows for a lower initial period fee in both the two rotation- required environments and the non -rotation required environment, the auditing price is higher in an environment with mandatory auditor rotation. .. board’s investigation strategy∗ Initial period Rotation- required 1 · B p B+D Non -rotation 1 · B p B+D Non-initial period ⎧ ⎨ ⎫ ⎬ B 1 N n+1 ⎭ p ⎩ B+D+(S+K )· (1+r ) −(1+r ) (1+r ) N −1 B 1 · p B+K +S+D N is the maximum length of the auditor–client relationship and n (2 ≤ n ≤ N ) is a given auditing period 123 278 W Chi Fig 1 Comparison of rotation- required and non -rotation- required investigation strategies, ... has to pay additional investigation costs in a mandatory rotation environment 16 Please note that the continuous lines in figures 1 and 2 link results for discrete cases Also, the descending bold line in both figures represents the initial periods for both the rotation- required and non -rotation- required regimes 123 An overlooked effect of mandatory audit–firm rotation 279 Table 2 Summary of the auditing... auditor rotation Briefly stated, in terms of audit fee payment, the mandatory rotation requirement represents a cost burden to the firm 17 In fact, the conclusion is not subject to the discounted zero-profit assumption, as long as the present value of the initial engagement in a non -rotation- required regime is constant That is, if we compare the rotation- required to the non -rotation- required environment, the... aggressiveness of the investigation strategy adopted by the board For comparison, the discounted future quasi-rents in non -rotation- required and rotation- required environments are different in all periods except the initial one A comparison of the two optimal investigation strategies in the non-initial period in the last column of Table 1 shows that the difference of these two strategies will converge to... cost burden of a higher audit fee payment increases when mandatory rotation is more frequent 5 Conclusion The study of mandatory audit–firm rotation is called for by section 207 of the SOX Act A particular feature of the current paper is that its discussion of the effectiveness of mandatory audit–firm rotation explicitly includes the assumption that section 301 of the SOX Act, which requires an independent... relationship and the quality of earnings: A case for mandatory auditor rotation? Account Rev 78(3):779–799 123 An overlooked effect of mandatory audit–firm rotation 285 National Commission on Fraudulent Financial Reporting (The Treadway Commission) (1987) Report of the National Commission on Fraudulent Financial Reporting Government Printing Of ce, Washington, D.C Omer T, Bedard J, Falsetta D (2006) Auditor-provided... scenarios, one of an investigation strategy with a shorter period of rotation, and another with a longer For a given shorter mandatory rotation period N 1, and a longer period N 2, Propositions 3–4 states that for all periods ∗ ∗ 2 ≤ n ≤ N 1, πn;R (N 1) > πn;R (N 2) In other words, the board should choose a more aggressive investigation strategy in a rotation- required environment with more frequent rotations... investigation strategy in a rotation- required environment over shorter and longer periods of rotation, while the thin line shows the investigation strategy in a non -rotation- required environment Proposition 3 states that the board chooses the most aggressive investigation level in the initial audit period, irrespective of whether auditor rotation is required or not.16 Please note that the continuous... and audit pricing Table 1 summarizes the board’s optimal investigation strategies in Propositions 1 and 2 via two dimensions— rotation- required versus non -rotation required” and “initial period versus noninitial period.” The following proposition summarizes the relative impact of the board’s optimal investigation strategies under the different regimes Proposition 3 For 2 ≤ n ≤ N : Table 1 Summary of . committee in non -rotation- required and rotation- required environments. Section 4 discusses the solution and explains the economic consequences of mandatory rotation. I present concluding remarks. rotation- required and non -rotation- required regimes. 123 An overlooked effect of mandatory audit–firm rotation 279 Table 2 Summary of the auditing pricing ∗ Initial period Non-initial period Rotation- required. audit–partner rotation, and section 207 requires a study of mandatory W. Chi ( B ) National Chengchi University, 64, Zhi-nan Road, Section 2, Wenshan, 11623 Taipei, Taiwan, Republic of China e-mail: wchi@nccu.edu.tw 123 266