Mandatory Audit Firm Rotation and Audit Quality: Evidence from the Korean Audit Market Soo Young Kwon Korea University Young Deok Lim University of New South Wales Roger Simnett University of New South Wales November 2010 We are grateful for the insightful comments from Michael Ettredge and participants at the seminars at the University of New South Wales Mandatory Audit Firm Rotation and Audit Quality: Evidence from the Korean Audit Market Abstract Using a unique database consisting of 12,463 firm-year observations in Korea between 2000 and 2007, this study examines the effect of mandatory audit firm rotation on audit hours, audit fees, and audit quality Since the Korean government mandated audit firm rotation in 2006, (1) audit hours increased, (2) audit fees increased, and (3) audit quality (measured as abnormal discretionary accruals) remained unchanged or decreased slightly These results, which are robust to controlling for potential endogeneity between audit hours and earnings management and to measuring audit quality alternatively, suggest that mandatory audit firm rotation increases the cost for audit firms and clients while having no discernable positive effect on audit quality Keywords: Mandatory Audit Firm Rotation, Audit Hours, Audit Fees, Audit Quality JEL Classifications: M42, M48 Data Availability: Most of the financial data used in the present study are available from the KIS Value database The data for audit hours and fees were drawn from statements of operating results filed with the Financial Supervisory Services (FSS) in Korea Mandatory Audit Firm Rotation and Audit Quality: Empirical Evidence from the Korean Audit Market Introduction The Korean Financial Supervisory Services (FSS) has mandated audit firm rotation in 2006 The mandatory audit firm rotation, which requires audit firms to be rotated every seven years, is intended to reduce auditors’ incentives to develop longterm relationships with their clients so that their preference for conservative accounting choices may be induced This study examines the effect of the mandatory audit firm rotation in Korea on audit hours, audit fees, and discretionary accruals Further, the study explores a forced auditor change setting that allows for a more direct examination of how audit quality is affected by a mandatory auditor change and an increase in auditor skepticism Whether audit firm rotation should be made mandatory is an issue that has been debated for almost five decades in the U.S and around the world Proponents of mandatory audit firm rotation have argued that a new auditor would bring to bear greater skepticism and a fresh perspective that may be lacking in long-standing auditor-client relationships.1 They have also claimed that when a company has been a client of an audit firm for a number of years, the client can be viewed as a source of a perpetual annuity, potentially impairing the auditor’s independence Conversely, opponents of mandatory firm rotation have argued that audit quality would suffer under such a regime because the auditor would lack familiarity with the client and its industry (AICPA [1992]) Furthermore, opponents have pointed to a higher incidence of problem audits in the early years of the auditor-client relationship than in the later years (St Pierre and Anderson [1984]) The Enron debacle in late 2001 (and its high-profile collapse) has refocused attention on the profession’s effectiveness in protecting public interest The SarbanesOxley Act [2002] required the General Accounting Office (GAO2) to conduct a study of the potential effects of requiring the mandatory rotation of auditors registered under the Act The GAO’s study concluded that mandatory audit firm rotation might Benson [2002] suggested that institutional investors have focused on this issue and opposed shareholder approval of any audit firm that has been retained by a company for more than five years Effective July 7, 2004, the GAO changed its name to the Government Accountability Office not be the most efficient way to strengthen auditor independence Consequently, the legislatures settled on the rotation of lead partners However, the GAO has left open the possibility of revisiting the mandatory audit firm rotation requirement if the other requirements of the Sarbanes-Oxley Act not lead to improved audit quality Thus, despite concerns that mandatory rotation could diminish the quality of financial reporting, the demand for mandatory audit firm rotation has remained Because the effects of mandatory firm rotation cannot be analyzed using archival data, prior research has examined the relation between audit quality and audit firm tenure As proxies for audit quality, they employ discretionary accruals, the cost of debt financing, earnings response coefficients (ERCs), going-concern reports, AAERs (Accounting and Auditing Enforcement Releases), auditor litigation, and fraud Overall, previous studies have suggested that long auditor tenure is not associated with a decline in audit quality but that short tenure is associated with lower quality audits (Geiger and Raghunandan [2002], Johnson et al [2002], Carcello and Nagy [2004], Myers et al [2003], Ghosh and Moon [2005]) However, no study has directly examined the effect of mandatory audit firm rotation because all have examined audit firm rotation in the context of a voluntary change regime Thus, the results of prior research may not extend to a mandatory change regime Because auditor change is widely known to be endogenously determined, the association between auditor tenure and audit quality has the self-selection bias (i.e., clients with long tenure tend to be good performers with less incentives to manage earnings) Furthermore, unlike those under a mandatory audit firm rotation regime, companies under a voluntary change regime are not required to change auditors in future, and thus, they may still retain bargaining power over successor auditors To date, few studies have examined the effect of audit firm rotation in the mandatory regime context because of the lack of data from a mandatory audit firm rotation environment However, Korea has mandated the audit firm rotation requirement since 2006 This allows a direct examination of the impact of a forced auditor change on audit quality under a mandatory audit firm rotation regime Furthermore, by employing publicly disclosed data on audit hours and fees to determine the effects of a forced auditor change on audit hours (auditor effort/cost) and audit fees (cost to clients), this study provides a better understanding of the costs and benefits of mandatory audit firm rotation Using a unique database consisting of 12,463 firm-year observations in Korea between 2000 and 2007, this study examines the effect of mandatory audit firm rotation on audit hours, audit fees, and audit quality Since the Korean government mandated audit firm rotation in 2006, (1) audit hours increased, (2) audit fees increased, and (3) audit quality (measured as abnormal discretionary accruals) remained unchanged or decreased slightly These results, which are robust to controlling for potential endogeneity between audit hours and earnings management and to measuring audit quality alternatively, suggest that mandatory audit firm rotation increases the cost for audit firms and clients while having no discernable positive effect on audit quality Our study contributes to the literature in several ways This study explicitly examines the impact of mandatory audit firm rotation on audit quality under a mandatory audit firm rotation regime Previous studies have examined either the effects of auditor tenure on earnings quality or the characteristics of firms voluntarily changing auditors on the engagement under a voluntary rotation system, not under a mandatory system.3 Thus, the results from a voluntary auditor change environment may not extend to a mandatory auditor change environment if such a requirement is imposed on public companies Second, to the authors’ knowledge, the present study is the first to employ the rich dataset of audit hours and audit fees to address an important policy question -the effect of mandatory auditor change on auditor efforts (auditor cost), audit fees (client cost), and discretionary accruals (audit quality) under one study Prior studies have employed audit tenure, the auditor’s opinion, or financial statement restatements to explore the impact of mandatory audit firm rotation However, they have not examined the rotation-related costs to clients and audit firms The present study has useful implications for regulators, members of the accounting profession, and financial statement users as they deliberate on the costs and benefits of mandatory audit firm rotation One recent study by Ruiz-Barbadillo et al [2009] examined the impact of mandatory audit firm rotation on auditor behavior in the Spanish context They used the likelihood of issuing going-concern opinions as a proxy for audit quality and focused on financially distressed firms from 1991~2000 Third, this study provides evidence for the incremental effect of mandatory auditor changes over voluntary auditor changes on auditor efforts, audit fees, and discretionary accruals Further, this study explicitly considers auditors’ responses to the rule by increasing audit hours; the auditors were expected to change their audit hours in anticipation of government scrutiny The remainder of the paper proceeds as follows Section provides a review of the controversy and literature about mandatory rotation Section develops the hypotheses, and Section presents the models and key variables Section describes the sample and reports the results Section provides additional analyses, and Section concludes with a summary Controversy over Mandatory Rotation and Literature Review 2.1 Debate on Mandatory Audit Firm Rotation 2.1.1 Controversy over Mandatory Audit Firm Rotation Among Politicians, Regulators, and Accounting Practitioners In their seminal work, Mautz and Sharaf [1961] suggested that extended auditorclient relationships can have a detrimental effect on auditor independence because an auditor’s objectivity about a client decreases over time Further, the Metcalf Committee indicated that mandatory audit firm rotation is a way to bolster auditor independence (U.S Senate [1976]) Regulators have suggested a link between auditor tenure and reductions in earnings quality and recommended imposing such a requirement (Commission on Auditors’ Responsibilities [1978]; Division for CPA firms, [1992]) The Enron scandal and the Andersen audit failure rekindled the issue of mandatory audit firm rotation Mandatory audit firm rotation was advocated in the congressional testimony by Arthur Levitt, Jr., former chairman of the SEC; Lynn E Turner, former SEC chief accountant; and Charles A Bowsher, a chair of the Public Oversight Board They suggested that serious consideration be given to requiring companies to change their audit firm every 5~7 years to ensure that fresh and skeptical eyes are always looking at the numbers Several bills containing provisions limiting auditor tenure and mandating auditor rotation were proposed in the House and the Senate as part of an effort to improve financial reporting and protect investors However, the views expressed above have not been universally accepted The Cohen Commission in 1978 concluded that mandatory rotation costs would exceed the benefits The auditing profession has argued that mandatory audit firm rotation would not only decrease audit quality but also increase the cost of an audit (AICPA [1992]) The 1996 GAO study opposed auditor rotation citing its detrimental impact on the value of continuity in conducting audits The AICPA’s Quality Control Inquiry Committee of the SEC Practice Section analyzed 406 cases of alleged audit failure between 1979 and 1991 and concluded that allegations of audit failure occurred almost three times as often when an audit firm was performing its first or second audit of a given client (AICPA [1992]) Given the conflicting views on auditor tenure, Congress decided in 2002 not to require the mandatory rotation of audit firms Instead, it directed the GAO to conduct research on the potential effects of mandatory audit firm rotation on audit quality; the GAO’s 2003 study concluded that mandatory audit firm rotation may not be the most efficient way to strengthen auditor independence and improve audit quality As a result, Congress decided that it was necessary to require mandatory partner rotation (not mandatory audit firm rotation) every five years to increase audit quality.4 However, the GAO has left open the possibility of revisiting the mandatory audit firm rotation requirement if the other requirements of the Sarbanes-Oxley Act not lead to improved audit quality (GAO [2003, 5]) In addition, several parties including the GAO [2003, 9], the New York Stock Exchange [2003, 11], the Commission on Public Trust and Private Enterprise [2003, 3], and TIAA-CREF [2004, 9] suggested that periodically changing audit firms may enhance audit quality Therefore, although mandatory rotation is not required at the present time, regulators, policy makers, and institutional investors have continued to be interested in this topic 2.1.2 Pros and Cons of Mandatory Audit Firm Rotation The most widely used arguments in favor of auditor rotation are as follows First, if auditors continue to audit the entity for too long, they risk developing too close a Following the Sarbanes-Oxley Act, the SEC issued its rules on audit partner rotation in 2003; Rule 201(c)(6) of Regulation S-X requires the mandatory rotation of the lead partner and the concurring partner every five years in relation to their audit client relationship with the client and compromising independence.5 Second, periodically having a new auditor would bring a fresh look to the public company’s financial reporting and help the auditor appropriately deal with financial reporting issues because the auditor’s tenure would be limited under mandatory audit firm rotation Third, mandatory audit firm rotation would help in the more even development of the auditing profession, helping smaller and medium-sized audit firms to grow There are several arguments against mandatory audit firm rotation First, new auditors may miss problems in the period under review because they lack adequate experience with the client to notice either unusual events or important changes in the client’s environment.6 Second, there are not enough large audit firms to address the audit requirements of large companies, making auditor rotation impracticable at the ground level Third, mandatory rotation increases audit start-up costs and the risk of audit failure because the incoming auditor places increased reliance on the client’s estimates and representations in the initial years of the engagement Thus, there may be negative effects on audit quality and effectiveness in the first years following a change Fourth, the rotation would only prevent auditors from building in-depth institutional knowledge of a client and its business.7 It appears that politicians, regulators, analysts, and small audit firms favor mandatory audit firm rotation as a solution to the perceived lack of objectivity and independence of auditors On the other hand, academicians, companies, and large audit firms tend to be against mandatory audit firm rotation because changing auditors is costly It is certainly interesting to observe such different perspectives on the same issue Without empirical evidence, it is neither clear whether mandatory rotation would really ensure audit quality by strengthening auditor independence nor obvious whether the rotation rule would hamper audit quality because of insufficient knowledge of clients For example, Waste Management, W R Grace, and JWP were identified as three cases in which, in the context of a long-term audit relationship, an issue was identified by the auditors but then not resolved (Turner [2001]) The accounting profession has argued that uncertainty about the characteristics of the client increases the potential for audit failures early in the auditor-client relationship (PricewaterhouseCoopers [2002]) Most obviously, the cumulative knowledge of the existing audit team is lost, and the new auditor faces a steep learning curve The increasing complexity of large groups and the complexities surrounding the financial reporting of their activities suggest that it can take the new auditor several years to fully understand the business (CGAA) The response to mandatory rotation varies from firm to firm Intel’s audit committee decided in 2003 to change its auditor regularly in the wake of calls by a number of advocates for better corporate governance Intel had been audited by Ernst & Young since the chipmaker was founded in 1968 However, the audit committee had decided that Intel might benefit from obtaining a fresh look at its financial accounting and internal control processes LESCO also reported in 2003 that its board of directors appointed KPMG as the company’s independent auditor by replacing Ernst & Young LESCO disclosed in a filing with the SEC that there were no disagreements between the company and Ernst & Young on any matter of accounting principles or practices, financial statement disclosure, or auditing scope or procedure By contrast, DuPont periodically rotated its auditor not only to assure disinterestedness on the part of the auditor but also to provide the company with a fresh perspective (Zeff [2003]) However, in 1954, it allowed Price Waterhouse & Co to remain as the permanent auditor, particularly in view of the increasing size and complexity of the company and its extensive overseas operations These two seemingly conflicting views under the voluntary auditor change setting suggest that no clear consensus has emerged in favor of or against the concept of auditor rotation 2.1.3 Trends in Mandatory Audit Firm Rotation Worldwide In the wake of a number of financial reporting failures (notably in the U.S but also in Europe), legislators and regulators have questioned the quality of auditors’ work The countries that already have an audit rotation system in place are Italy, Brazil, Malaysia, Singapore, and Korea Italy has a statutory requirement for audit firm rotation every nine years In Brazil, companies have been made to change auditing firms every three years In Singapore, banks are required to change audit firms every five years, but there is no requirement on listed companies In 2003, Korea adopted the mandatory rotation rule and required listed firms to rotate their auditors every six years starting in 2006 Spain introduced mandatory rotation in 1988 after a maximum period of nine years but abolished the mandatory rotation requirement in 1995 In 1998, France considered the reform proposal with a provision to limit the term of the statutory auditor to six years but dropped the provision from the proposal at the final stage Similarly, Austria approved a law in 2002 that required audit firm rotation by the end of six years, but the requirement has been put on hold The U.K concluded that the mandatory rotation of firms was not necessary Instead, it decided to increase the frequency of rotation for the lead audit partner to every five years Hong Kong also adopted audit partner rotation in 2003 by requiring lead audit partners to be rotated every five years Federation des Experts Compatables Europeans (FEE) recommended in its letter to the European Commission that the proposed Directive be amended to omit the suggestion that the mandatory rotation of audit firms should be seen as an alternative to the mandatory rotation of partners Accordingly, none of countries in Europe have introduced mandatory audit firm rotation 2.2 Literature Review of Mandatory Audit Firm Rotation Some studies have reported results consistent with the perspective that audit quality deteriorates as the length of audit tenure increases Mautz and Sharaf [1961] suggested that extended client-auditor relationships alone impede auditor independence Deis and Giroux [1992] reviewed audit quality letters produced by a public audit agency and concluded that audit quality declines as audit tenure increases Davis et al [2002] suggested that longer auditor tenure is associated with the use of discretionary accruals to manage earnings This argument is reinforced by Bazerman et al [2002], who provided evidence of stronger psychological bias with increasing ties between the auditor and its client Dopuch et al [2001] concluded that mandatory rotation can increase auditor independence because rotation requirements constrain low-balling in anticipation of potential income from future engagements On the other hand, other studies have provided conflicting results St Pierre and Anderson [1984] and Stice [1991] suggested that many audit errors and lawsuits occur during early years of the client-auditor relationship Geiger and Raghunandan [2002] determined that auditors become more efficient at collecting and evaluating audit evidence as tenure increase Carcello and Nagy [2004] proposed that the probability of fraudulent financial reporting is highest early in the audit firm’s tenure and is not substantially higher for instances of longstanding audit engagements Myers et al [2004] found no evidence of an association between the nature and severity of the restatement and auditor tenure Mansi et al [2004] suggested that TABLE Correlation Matrix of Study Variables (0.00) (0.96) (