124 Economics, Management, and Financial Markets Volume 9(1), 2014, pp. 124–129, ISSN 1842-3191 THE EFFECT OF MANDATORY PARTNER ROTATION ON AUDIT QUALITY LUMINIŢA IONESCU luminita.ionescu@spiruharet.ro Spiru Haret University ABSTRACT. The theory that I shall seek to elaborate here puts considerable emphasis on possible consequences of mandatory auditor rotation, the effect of auditor tenure on audit quality, and the pros and cons of mandatory rotation. Related topics I will explore include mechanisms that facilitate audit partner rotation, the consequences of mandatory partner rotation, and the impact of mandatory partner rotation on audit quality. JEL Codes: H83; M4 Keywords: audit partner rotation; mandatory; quality; firm 1. Introduction I am specifically interested in how previous research investigated the potential erosion of client-specific and industry knowledge resulting from mandatory audit partner rotation, the desirability of mandatory rotation, and the associ- ation between earnings quality and auditor rotation. The mainstay of the paper is formed by an analysis of the association between both audit firm and partner tenure and audit quality, the consequences of mandatory audit firm rotation, the potential benefits of audit firm rotation using mandatory rotators data, and mandatory rotation as a way to promote a more independent auditor- client relationship. 2. Mechanisms that Facilitate Audit Partner Rotation Holding audit quality constant, mandatory rotation does not directly affect the quality of the client’s pre-audit financial statements. A change of partner may worsen audit quality (partners may gain more knowledge from longer tenure with the client), whereas a change of audit partner may improve audit quality by bringing a fresh perspective to an audit. Mandatory rotation can 125 improve audit quality in the year before rotation occurs and in the year of appointment of the new partner. Audit reports in China (Popescu, 2013d) disclose the names of the engagement and review partners. The review part- ner and the engagement partner share the same legal liability (unless there is contrary evidence) and are subject to the same rules on mandatory rotation (audit firms in China are allowed to organize as limited liability companies or as partnerships). The rules in China allow for simultaneous rotation of both the engagement partner and the review partner. Auditors are required to judge whether a misstatement is material by considering both its quantitative magnitude and any relevant qualitative factors. Audit adjustments occur more often when the engagement partner is scheduled for mandatory rotation at the end of the year, and during the incoming partner’s first year of tenure than in other years. A newly appointed partner is more likely to detect and correct financial reporting problems (Popescu, 2013c) during his first year of tenure. Mandatory partner rotation has a beneficial effect in the final year of tenure before rotation occurs and in the subsequent year when the new partner is appointed. The higher frequency of audit adjustments surrounding partner rotation is not attributable to differences of judgment between the departing partner and the new partner. Mandatory partner rotation has a ben- eficial impact on audit quality even in the absence of mandatory audit firm rotation, can have a positive impact on audit quality, and significantly in- creases the frequency of audit adjustments. The positive association between audit firm tenure and audit quality can reflect the underlying factors that cause voluntary switches. (Lennox, Wu, and Zhang, 2014) Increased client-specific knowledge provides a comparative advantage in detecting material misstatements in financial reports. Individual auditors store information about the client in memory and the audit firm stores information about the client in audit work papers. The CLERP 9 regulatory changes on mandatory audit partner rotation have been effective in improving audit qual- ity. Auditors tend to issue going-concern opinions for financially distressed companies (Nicolăescu, 2012) when audit partner tenure is equal to or more than the mandated period. There is a significant and positive association between long audit partner tenure and the likelihood of issuing a going- concern opinion for a financially distressed company. (Monroe and Hossain, 2013) Audit firm rotation automatically implies audit partner rotation, unless the lead audit partner and the client move together to another audit firm. Turnovers of auditors within the audit firm unlikely affect the economic incentives (Nicolăescu, 2013c) of the audit firm with respect to the client. A rotation of the audit firm automatically implicates that a new audit partner will be responsible for the client. Mandating audit firm rotation might have a positive effect on the asymmetric timeliness of loss recognition (i.e. conser- 126 vatism). Conservatism is an important attribute of earnings quality. (Kramer et al., 2011) 3. The Consequences of Mandatory Partner Rotation Audit quality is higher during the engagement partner’s final year of tenure prior to mandatory rotation and during the engagement partner’s first year of tenure following mandatory rotation. Audit adjustments occur more frequently when the engagement partner is in his final year of tenure prior to mandatory rotation. The fresh eyes effect is limited to the engagement partner’s first year of tenure and does not extend to the second year. Larger companies and companies with higher leverage are less likely to require audit adjustments, whereas audit adjustments occur more often when ownership structures are more complex. Audit adjustments occur more often in the years surrounding audit partner rotation. The mandatory rotation of engagement partners is associated with more frequent large adjustments and more frequent small adjustments (Nica, 2012), mandatory rotation helping engagement partners to detect and correct both quantitatively small and quantitatively large misstate- ments. Auditors are more likely to require profits to be adjusted downwards rather than upwards. Engagement partners require more upward adjustments and more downward adjustments in their final years of tenure prior to man- datory rotation, and work harder to detect and correct financial reporting problems during their final years of tenure. New engagement partners bring a fresh perspective to the audit, being more likely to detect overstatements and understatements of profits. (Lennox, Wu, and Zhang, 2014) Auditing firms likely recognize the benefits of periodic engagement per- sonnel rotation. Audit partners of larger firms are more likely to believe rotation negatively impacts audit quality. Smaller firms may have fewer clients subject to the rotation rules (Popescu, 2013b) as a percentage of their entire practice. Smaller auditing firms may have been disproportionately negatively impacted by SOX mandates. Accelerated rotation may have more negative impacts on smaller firms with fewer resources. (Daugherty, Dickins, and Higgs, 2011) Politically connected firms may be reluctant to appoint Big Four auditors to improve accounting transparency. Political connections can add value to all shareholders, and engender agency conflicts between dominant insiders and outside investors. Minority investors become more susceptible to expropriation as the ownership-control gap widens. Firms with a single large shareholder suffer worse agency conflicts with outside investors. Large shareholders in business groups (Nica, 2013) can exploit pyramidal ownership to secure control rights that far exceed their equity stakes. The separation of cash flow rights from voting rights in firms affiliated with a business group 127 (Nicolăescu, 2013a) magnifies agency costs. Exploiting connections to orches- trate the diversion of corporate resources requires hiding. (Guedhami, Pittman, and Saffar, 2014) 4. The Impact of Mandatory Partner Rotation on Audit Quality Audit adjustments occur more often in the engagement partner’s first year of tenure following mandatory partner rotation. Voluntary rotations are much more common than mandatory rotations. Engagement partners and review partners are less likely to be voluntarily rotated off the audit after they make adjustments to the client’s pre-audit profits, an audit firm preferring partner continuity when a client is found to have financial reporting problems requir- ing audit adjustments. One cannot draw valid inferences about mandatory rotation by examining situations in which partners are rotated voluntarily. Audit adjustments are significantly more frequent in the first year of tenure following mandatory partner rotation, and are less frequent in the first year of tenure following voluntary rotation. Mandatory rotation results in higher audit quality. A newly appointed engagement partner tends to require adjust- ments during his first year of tenure following mandatory rotation. Mandatory partner rotation can be beneficial in terms of increasing the frequency with which partners detect and do not waive adjustments, and occurs relatively infrequently, while audit firm tenure is typically quite long. (Lennox, Wu, and Zhang, 2014) Policy makers recognize explicitly the difference between voluntary and mandatory auditor changes. (Casterella and Johnston, 2014) Option backdating possesses two basic features of accounting fraud – in- centive and opportunity. Compensation expenses need to be disclosed in the footnotes of financial reports (Popescu, 2013e) and audited by independent external auditors. Audit tenure is the length of the auditor-client relationship (Nicolăescu, 2013b) as of the fiscal year-end in the financial statements. Longer audit tenure is positively associated with the likelihood of option backdating, whereas the positive effect is more pronounced when the audit tenure is longer than ten years. Firms with larger stock return volatility (Popescu, 2013a) are more likely to backdate their stock options. Long audit tenure is positively associated with the likelihood of stock option backdating, a form of accounting fraud. The detrimental effect of long audit tenure is more pronounced in larger audit clients. (Ouyang and Wan, 2013) Mandatory audit partner rotation interrupts the accumulation of audit part- ners’ industry-specific knowledge and expertise. An audit partner’s within- industry market share is a less reliable proxy for audit partner industry exper- tise under the mandatory audit partner rotation regime. The audit partner’s within-industry market share reliably captures audit partner industry expertise in the voluntary partner rotation regime. Mandatory audit partner rotation 128 has decoupled the link between the audit partner’s within-industry market share and audit partner industry expertise. Mandatory partner rotation forces changes in the market shares of incoming and departing partners. The audit partner’s within-industry market share is artificially increased or decreased by mandatory rotation. Audit quality is no longer positively associated with the audit partner’s within-industry market share. In the voluntary partner rotation regime, auditors who are industry experts at both the firm and part- ner levels enhance audit quality. Mandatory audit partner rotation artificially increases or decreases an auditor’s within-industry market share (Nicolăescu, 2013d), and makes an auditor’s within-industry market share a noisy proxy for auditor industry expertise. Audit quality is positively related to auditor industry expertise proxied by the auditor’s within-industry market share in the voluntary audit partner rotation regime (an audit partner’s market share in an industry is determined by the free choice of the market). (Wuchun, Hsiumei, and Hong, 2014) 5. Conclusions The paper generates insights about the associated costs and benefits of man- datory audit firm rotation, the effect that mandatory rotation may have on auditor independence and audit quality, and the concept of mandatory auditor rotation. My paper contributes to the literature by providing evidence on the role of auditor industry expertise on audit quality, the impact of the duration of auditor-client relationships on audit quality, and the effects of audit part- ner rotation on audit quality. 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REFERENCES Casterella, Jeffrey R., and Derek Johnston (2014) ,. quality, and the concept of mandatory auditor rotation. My paper contributes to the literature by providing evidence on the role of auditor industry expertise on audit quality, the impact of. and cons of mandatory rotation. Related topics I will explore include mechanisms that facilitate audit partner rotation, the consequences of mandatory partner rotation, and the impact of mandatory