Contemporary Accounting Research Vol. 26 No. 2 (Summer 2009) pp. 359–91 © CAAA doi:10.1506/car.26.2.2 Mandatory Audit Partner Rotation, Audit Quality, and Market Perception: Evidence from Taiwan* WUCHUN CHI, National Chengchi University HUICHI HUANG, Syracuse University YICHUN LIAO, National Taiwan University HONG XIE, University of Kentucky 1. Introduction Mandatory audit partner rotation has existed in the United States since the 1970s, when the American Institute of Certified Public Accountants (AICPA) required that audit partners in charge of Securities and Exchange Commission (SEC) audits be rotated at least once every seven years. The Sarbanes-Oxley Act of 2002 (SOX) further strengthens this requirement by mandating a five-year rotation for the lead and concurring partners. An implicit assumption in a policy of mandatory partner rotation is that such rotation enhances audit quality. However, this assumption has not been systematically tested in the literature due to the lack of partner informa- tion in U.S. audit reports. Unlike in the United States, audit reports in Taiwan contain both audit firm and audit partner names. Exploiting this institutional feature, Chen, Lin, and Lin (2008) and Chi and Huang (2005) examine the relation between earnings quality and partner tenure. They find that earnings quality tends to increase in partner tenure, consistent with findings in the United States based on audit firm tenure. However, their sample periods are prior to 2003 when partner rotation in Taiwan was voluntary. These studies, thus, do not directly investigate the effect of mandatory audit part- ner rotation on earnings quality or audit quality. 1 In this paper, we use audit data in Taiwan, where a five-year audit partner rota- tion became de facto mandatory in 2004, to examine the effectiveness of mandatory audit partner rotation in promoting audit quality and perceived audit quality. Inspired by SOX, two principal stock exchanges in Taiwan — Taiwan Stock * Accepted by Michael Willenborg. An earlier version of this paper was presented at the 2005 Con- temporary Accounting Research Conference, generously supported by the Canadian Institute of Chartered Accountants , the Certified General Accountants of Ontario , the Certified Man- agement Accountants of Ontario , and the Institute of Chartered Accountants of Ontario . We appreciate valuable comments from Linda Bamber (discussant), Rajib Doogar, Chan-Jane Lin, James Myers, Dan Simunic, Ira Solomon, Theodore Sougiannis, Michael Willenborg (associate editor), two anonymous reviewers, participants at the 2005 Contemporary Accounting Research Conference, and workshop participants at National Chengchi University and National Taipei Uni- versity. Professor Chi gratefully acknowledges the financial support from National Science Council (NSC 93-2416-H-004-036). 360 Contemporary Accounting Research CAR Vol. 26 No. 2 (Summer 2009) Exchange Corporation (TWSE) and GreTai Securities Market (GTSM) — adopted a set of rules in April 2003 that, in effect, require a five-year mandatory partner rotation. 2 These rules became fully effective in 2004 for both semi-annual and annual reports, with 2003 as a transition period (more detail below). We use the 2004 semi-annual reports of Taiwanese companies listed in the Taiwan Economic Journal (TEJ) database for this study. Semi-annual reports in Taiwan are audited no differently from annual reports, and the 2004 semi-annual reports are the first set of data that reflect the full force of the mandatory partner rotation rule in Taiwan. Following prior studies (e.g., Myers et al. 2003), we examine the effect of mandatory audit partner rotation on audit quality using absolute and signed performance-matched abnormal accruals (Kothari, Leone, and Wasley 2005) as proxies for audit quality. We identify a sample of companies in 2004 whose audit partners were subject to mandatory rotation within the same audit firm (the manda- tory rotation sample) and compare it with three benchmark samples. 3 First, we compare the mandatory rotation sample with companies in 2004 whose audit part- ners were not subject to mandatory rotation (the nonrotation sample). We find no difference in audit quality between these two samples. Second, we compare the mandatory rotation sample with itself one year earlier (2003) (the mandatory rotation sample in the prior year). We find that the audit quality of companies in the manda- tory rotation sample under new audit partners is lower than the audit quality of these same companies one year earlier under old audit partners. Third, we compare our mandatory rotation sample with companies in years before 2003 whose audit partners were voluntarily rotated within the same audit firm (the voluntary rotation sample). We again find no difference in audit quality between these two samples. In sum, we find no support for the belief that mandatory audit partner rotation enhances audit quality. Our findings are robust to various sensitivity checks. Next, we examine the effect of mandatory audit partner rotation on investor perceptions of audit quality, using the earnings response coefficient (ERC) as a proxy for perceived audit quality (Teoh and Wong 1993; Ghosh and Moon 2005). After controlling for common determinants of the ERC, we find that the ERC of the mandatory rotation sample is not significantly different from that of the non- rotation sample or that of the mandatory rotation sample in the prior year, but is significantly larger than the ERC of the voluntary rotation sample. Overall, we find no consistent support for the belief that mandatory audit partner rotation enhances investor perceptions of audit quality. This paper contributes to the literature on auditor tenure and audit quality. To our knowledge, we are among the first to directly examine the effect of mandatory partner rotation on audit quality. Our findings are inconsistent with the implicit belief in a mandatory partner rotation policy that such rotation enhances audit quality or perceptions of audit quality. Rather, our findings are consistent, in spirit, with findings in the United States that mandatory audit firm rotation may not nec- essarily improve audit quality (Johnson, Khurana, and Reynolds 2002; Myers et al. 2003; Ghosh and Moon 2005; Blouin, Grein, and Rountree 2007). Our findings, however, must be interpreted with caution. Our inferences about the effect of mandatory partner rotation on audit quality and perceptions of audit Mandatory Audit Partner Rotation, Audit Quality, and Market Perception 361 CAR Vol. 26 No. 2 (Summer 2009) quality critically depend on the ability of our accrual-based proxies (abnormal accruals) and market-based proxy (ERC) to capture audit quality and perceived audit quality. Although widely used in the accounting literature, both types of proxies are noisy, which weakens our inferences. In addition, our findings, based on Taiwanese data, may not be generalizable to a post-SOX U.S. audit market or other audit markets where mandatory audit partner rotation is adopted, due to insti- tutional differences between Taiwan and those markets. We note, however, that accounting and auditing standards in Taiwan are similar to those in the United States and that important empirical regularities in the U.S. audit market (e.g., Myers et al. 2003) can also be found in Taiwanese audit data (Chen et al. 2008). Thus, there are significant similarities between Taiwan and the United States, mak- ing our findings relevant for the U.S. audit market. The remainder of the paper is organized as follows. Section 2 describes Taiwan- ese regulation of mandatory audit partner rotation. Section 3 reviews the literature and develops hypotheses. We describe data and sample selection in section 4. We present empirical models and findings in section 5 and conclude in section 6. 2. Mandatory audit partner rotation in Taiwan Unlike in the United States, where audit reports of public companies show only audit firm names, audit reports in Taiwan show both firm and partner names. 4 Again unlike in the United States, where partner rotation every seven years has long been required, audit partner rotation in Taiwan was entirely voluntary until 2003. In April 2003, after the passage of SOX in the United States, TWSE and GTSM, two principal stock exchanges in Taiwan, promulgated two rules that, in effect, require a five-year mandatory partner rotation. First, both stock exchanges amended the procedures for auditing the financial statements of listed companies and added a clause, stating that if the lead or concurring partner has performed audit services for a listed company in five consecutive years (applied retroactively), then that company’s financial statements are subject to the stock exchange’s “substantive review” procedure. 5 Specifically, the stock exchange audits financial statements of a company targeted for substantive review and takes appropriate actions if significant irregularities are found (more below). Second, there was a large percentage of audit firms with both partners auditing the same client in the previous four or more years in Taiwan as of 2003. The Taiwanese Accountants Union argued that it would be difficult for audit firms, especially small audit firms, to rotate two partners in the same year. In response to this and other concerns, both stock exchanges postponed the effective time for full implementation of the five- year rule for both audit partners to 2004, with 2003 (annual audits) as a transition period when audit firms were allowed to have one partner, but not both, auditing the same client for five or more years. After a stock exchange determines that a company’s financial statements are subject to substantive review, it will request and review audit working papers from the audit partners. If the exchange finds significant violations of accounting or auditing standards, it will refer the case to relevant government agencies for 362 Contemporary Accounting Research CAR Vol. 26 No. 2 (Summer 2009) administrative or punitive actions, which range from reprimand to suspension of license or even criminal charges. Because the potential punishments are severe, the two stock exchanges’ new rules that subject a company’s financial statements to substantive review when audited by the same lead or concurring audit partner in the recent five consecutive years, in effect, mandate a five-year rotation for both partners. 3. Literature review and hypothesis development The separation of ownership and control in public companies creates conflicts of interest between management and outside stakeholders. Due to the conflicts of inter- est and asymmetric information, financial statements prepared by management are audited by a third party (an auditor) to mitigate agency costs (Watts and Zimmer- man 1986). The value of an audit, however, depends on audit quality, which, in turn, depends on auditor competence and independence (DeAngelo 1981). 6 Auditor competence and independence thus are critically important to the value or per- ceived value of an audit. 7 Mandatory audit partner rotation and audit quality Mandatory audit partner rotation is adopted or considered in many countries as a mechanism to enhance auditor independence and audit quality. In the United States, the AICPA has required partner rotation every seven years since the 1970s. Moreover, SOX section 203 mandates a five-year rotation for the lead and review- ing partners. Internationally, mandatory partner rotation is currently practiced in Australia (Carey and Simnett 2006), Singapore, United Kingdom, France, Spain, the Netherlands, Japan, and Germany, and is being considered in Canada (General Accounting Office [GAO] 2003, Appendix V). The arguments for and against mandatory partner rotation, to a certain extent, are parallel to those for and against mandatory audit firm rotation and center on the costs and benefits of the rotation. The costs of mandatory partner rotation include (a) increased likelihood of audit failures due to new partners’ lack of client-specific knowledge of risk, operations, and financial reporting practices in the initial years (American Institute of Certified Public Accountants [AICPA] 1992; Pricewater- houseCoopers 2002); and (b) direct increases in costs incurred by both audit firms and client companies due to the need for the new partner(s) to become familiar with the client practices. The benefits of mandatory partner rotation, on the other hand, include a “fresh look” by the new partner(s) and enhanced auditor independ- ence. 8 The adoption of mandatory partner rotation in the United States and else- where suggests that the regulators believe that the benefits of rotation outweigh the costs and thus a policy of mandatory partner rotation enhances audit quality. How- ever, as we review below, the validity of such a belief has not been tested in the accounting literature. Literature review Prior studies often use absolute and signed abnormal accruals as proxies for earn- ings quality or audit quality. 9 Abnormal accruals have become an accepted proxy for earnings management, and thus earnings quality, in the accounting literature Mandatory Audit Partner Rotation, Audit Quality, and Market Perception 363 CAR Vol. 26 No. 2 (Summer 2009) (e.g., Healy and Wahlen 1999; Kothari 2001). A main justification for also using abnormal accruals as a proxy for audit quality is that audited financial statements should be viewed as a joint outcome from the audit firm and company management (Antle and Nalebuff 1991) — that is, earnings quality as captured by abnormal accruals is also affected by the audit firm and thus reflects audit quality. Another justification for using abnormal accruals as a proxy for audit quality is the large volume of studies documenting a link between abnormal accruals and audit quality. For example, Heninger (2001) documents a positive relation between auditor litigation and the level of income-increasing abnormal accruals. Menon and Williams (2004) find that companies employing former audit partners as offic- ers or directors (“the revolving door”) report larger signed and unsigned abnormal accruals. Richardson, Tuna, and Wu (2002) show that earnings restatements are positively related to various accrual measures. Finally, many studies use abnormal accruals as a metric to gauge audit quality differential between, for example, Big 6 and non–Big 6 auditors (Becker et al. 1998) and between auditors with and with- out industry expertise (Krishnan 2003). Using accrual-based proxies for audit quality, recent studies have examined the relation between audit firm tenure and audit quality. For example, Johnson et al. (2002) document that short audit firm tenure of two to three years is associated with lower-quality financial reporting relative to medium (four to eight years) or long (nine or more years) tenure. Similarly, Myers et al. (2003) find a positive rela- tion between audit quality and audit firm tenure. Several recent studies examine the relation between audit partner tenure and audit quality. For example, using data from Australia, where partner information is publicly disclosed and when partner rotation was voluntary, Carey and Simnett (2006) find a diminution in audit quality, as proxied by the propensity to issue going-concern opinions and the incidence of just beating (missing) earnings benchmarks, for long partner tenure. In contrast, using data from Taiwan when partner rotation was voluntary, Chen et al. (2008) find that audit quality, as measured by absolute abnormal accruals, increases with partner tenure after controlling for audit firm tenure. On the other hand, Chi and Huang (2005) find that audit quality, as proxied by signed abnormal accruals, initially increases but starts to decrease as partner tenure exceeds five years when they examine the effect of partner tenure alone on earnings quality. 10 After including audit firm tenure in regression analy- ses, they find that audit quality initially increases in audit firm tenure but starts to decrease as firm tenure exceeds five years but the coefficients on partner tenure and partner tenure squared are both insignificant. Recent studies also use market-based measures, such as the cost of debt and the ERC, as proxies for investor perceptions of audit quality. For example, Mansi et al. (2004) find a significantly negative relation between the cost of debt and audit firm tenure, suggesting that audit firm tenure enhances audit quality. 11 Similarly, Ghosh and Moon (2005) use the ERC as a proxy for investor perceptions of audit quality and find a positive association between perceived audit quality and audit firm tenure. 364 Contemporary Accounting Research CAR Vol. 26 No. 2 (Summer 2009) Hypotheses To summarize, recent studies on audit firm tenure suggest that audit quality increases with firm tenure, consistent with a “learning curve” for new auditors and the critical importance of client-specific knowledge and experience, which can only be acquired over time with the client, for producing a high-quality audit. Recent studies on audit partner tenure, however, produce conflicting evidence regarding the relation between partner tenure and audit quality. Importantly, all these studies examine the relation between auditor tenure (firm or partner) and audit quality under voluntary rotation regimes and, thus, do not directly examine the effect of mandatory partner rotation on audit quality. Because the incentives and behavior of auditors may change significantly under a mandatory rotation regime, relative to a voluntary rotation regime, whether prior findings under a vol- untary audit firm or partner rotation regime can be generalized to a mandatory audit firm or partner rotation regime is ultimately an empirical question (Johnson et al. 2002, 640; Myers et al. 2003, 796; Ghosh and Moon 2005, 588; Carey and Simnett 2006, 674). In brief, the extant literature has not examined the effect of mandatory audit partner rotation on audit quality and has not tested the validity of the implicit belief that mandatory audit partner rotation enhances audit quality. We examine the effect of mandatory audit partner rotation on audit quality and perceptions of audit quality using audit data from Taiwan under the mandatory partner rotation regime. We formulate the following two hypotheses (stated in alternative form) based on the implicit assumption in a mandatory partner rotation policy: H YPOTHESIS 1. The audit quality of companies whose audit partners are man- datorily rotated is higher than the audit quality of companies whose audit partners are not required to rotate. H YPOTHESIS 2. Investor perceptions of audit quality of companies whose audit partners are mandatorily rotated are higher than investor percep- tions of audit quality of companies whose audit partners are not required to rotate. 4. Sample selection and data Data for this study are collected from the 2004 semi-annual TEJ database for com- panies listed on TWSE or GTSM. We identify a sample of companies in 2004 whose audit partners (at least one of them) were subject to mandatory rotation (MROTA sample) and another sample of companies in 2004 whose partners (both of them) were not required to rotate (NROTA sample) using the following procedure. First, we identify 1,022 companies in 2002 (annual data) from the TEJ database after excluding three Taiwan depository receipts (TDR) because semi-annual finan- cial statements of TDRs are only reviewed rather than audited. 12 We delete 21 companies with missing audit partner information and three companies with non- calendar fiscal year-ends. We thus obtain a preliminary sample of 998 companies in 2002. Mandatory Audit Partner Rotation, Audit Quality, and Market Perception 365 CAR Vol. 26 No. 2 (Summer 2009) Second, we trace audit partners of these 998 companies in past years up to 2002 and find 832 companies with at least one partner who had performed audit services for the same client for at least four consecutive years by the end of 2002 and 166 companies with both partners who had performed audit services for the same client for less than four consecutive years by 2002. We classify the 832 com- panies into our mandatory rotation sample (MROTA), because at least one audit partner is subject to rotation either for the 2003 annual audits or 2004 semi-annul audits. 13 On the other hand, we classify the 166 companies identified above into the nonmandatory rotation sample (NROTA) because none of their audit partners is subject to mandatory rotation for the 2004 semi-annual audits. Third, we trace audit partners of companies in our MROTA and NROTA sam- ples to years 2003–4 to determine whether they are rotated for 2004 semi-annual reports. We lose additional companies for the following reasons in the MROTA (NROTA) samples: (a) 30 (7) companies due to delisting; (b) 78 (not applicable) companies due to their changing audit firms during 2003 and 2004; 14 (c) 109 (0) companies because one audit partner was rotated off in 2003 but came back in 2004; 15 (d) 1 (0) company because both audit partners were rotated off in 2003 but at least one came back in 2004; (e) 15 (0) companies for which one audit partner should have been rotated in 2004 but was not rotated; (f) 28 (0) companies for which both audit partners should have been rotated in 2004 but only one audit part- ner was rotated; (g) 18 (23) companies in financial industries whose accruals are difficult to interpret; (h) 54 (9) companies with missing data for tracing audit firm tenure; and (i) 6 (2) companies due to our requirement of at least eight observa- tions to estimate abnormal accruals for each industry-year combination using the modified Jones 1991 model. The above process generates 493 (125) companies in our MROTA and NROTA samples, respectively. Table 1, panel A summarizes the sample selection process. To test our hypotheses, we compare the MROTA sample with three bench- marks. The first benchmark is the nonrotation sample (NROTA) described above. The second benchmark is the mandatory rotation sample itself in the prior year (MBEFR sample). MBEFR and MROTA samples thus contain exactly the same companies, but semi-annual financial statements of MBEFR sample were audited under the old audit partners in 2003, whereas those of the MROTA sample were audited under new audit partners (at least one) in 2004. The third benchmark is the voluntary rotation (VROTA) sample described below. The sample selection process for our VROTA sample is summarized in Table 1, panel B. Specifically, we identify companies before 2003 for which at least one partner was voluntarily rotated within the same audit firm. We want to have roughly the same number of observations in VROTA as in MROTA, and need only go back to 1999 because we already identified 638 company-year observations by 1999. We delete 77 observations in financial institutions, 41 observations due to missing audit firm tenure, and 7 observations due to fewer than eight companies in their industry classifications in a year. The final VROTA sample consists of 513 company-year observations. 366 Contemporary Accounting Research CAR Vol. 26 No. 2 (Summer 2009) 5. Empirical models and findings In this section, we examine the effect of mandatory audit partner rotation on audit quality and investor perceptions of audit quality. We first present the empirical model and findings using accrual-based proxies for audit quality, and then the empirical model and findings using the market-based proxy for perceived audit quality. Accrual-based proxies for audit quality Variable measurement and empirical model Johnson et al. (2002) and Myers et al. (2003) use the Jones 1991 model-estimated abnormal accruals as proxies for audit quality. We use the modified Jones model TABLE 1 Sample selection Panel A: MROTA and NROTA sample selection Companies on TWSE or GTSM in 2002 from the TEJ database after deleting 3 TDRs 1,022 Less Companies with missing audit partner information (21) Companies with noncalendar year-end (3) Preliminary sample 998 Preliminary sample 832 166 Less Companies delisted in 2003 or 2004 (30) (7) Companies switching audit firms in 2003 or 2004 (78) (N/A) * Companies rotating one audit partner in 2003 but the audit partner came back in 2004 (109) (0) Companies rotating both audit partners in 2003 but one of them came back in 2004 (1) (0) Companies rotating both audit partners in 2003 but both came back in 2004 (0) (0) Companies should rotate one audit partner but rotated none (15) (0) Companies should rotate both audit partners but rotated only one (28) (0) Companies should rotate both audit partners but rotated none (0) (0) Companies in financial institutions (18) (23) Companies with missing data for tracing audit firm tenure (54) (9) Companies with less than eight observations in a industry-year combination (6) (2) Final sample 493 125 (The table is continued on the next page.) Sample label MROTA NROTA Mandatory Audit Partner Rotation, Audit Quality, and Market Perception 367 CAR Vol. 26 No. 2 (Summer 2009) (Dechow, Sloan, and Sweeney 1995) to estimate abnormal accruals and then do performance matching according to Kothari et al. (2005) because they demonstrate that performance-matched abnormal accruals capture earnings management better than do traditional Jones model-estimated abnormal accruals. Specifically, we first estimate raw abnormal accruals ( MJAbnA ) as the residu- als from the modified Jones model below (company subscript i is omitted except in places where doing so causes confusion): TAC t / TA t Ϫ 1 ϭ ␣ t (1/ TA t Ϫ 1 ) ϩ ␤ t ( ⌬ SALES t / TA t Ϫ 1 Ϫ ⌬ AR t / TA t Ϫ 1 ) ϩ ␥ t ( PPE t / TA t Ϫ 1 ) ϩ ␧ t (1), where TAC t ϭ total accruals in the first half of year t , calculated using the statement of cash flow approach recommended by Hribar and Collins 2002 ϭ income before discontinued operations and extraordinary items Ϫ (cash from operations Ϫ discontinued operations and extraordinary items from the statement of cash flows); ⌬ SALES t ϭ change in sales revenue between the first half of year t and the first half of year t Ϫ 1; TABLE 1 (Continued) Panel B: VROTA sample selection 2002 157 157 2001 220 377 2000 143 520 1999 118 638 Less Observations in financial institutions (77) Observations with missing data for tracing audit firm tenure (41) Observations with fewer than eight companies in an industry-year combination (7) Final sample 513 Note: * When a company in the preliminary NROTA sample switches its audit firm or rotates audit partners within the same audit firm, that company is still included in the NROTA sample because the switch of audit firm or rotation of audit partners is not required by the mandatory partner rotation rule. Number of companies Cumulative company-year observations 368 Contemporary Accounting Research CAR Vol. 26 No. 2 (Summer 2009) ⌬ AR t ϭ change in accounts receivable between the first half of year t and the first half of year t Ϫ 1; PPE t ϭ gross amount of property, plant, and equipment at the end of the first half of year t ; and TA t Ϫ 1 ϭ total assets at the end of year t Ϫ 1 (i.e., total assets at the beginning of the first half of year t). We estimate (1) in the cross-section in each year (from 1999 to 2004) for each TEJ industry classification with at least eight observations using all companies with required data in the TEJ database. We then do performance matching based on current-period return on assets (ROA t ). Specifically, for each company i (i ϭ 1, 2, , n, and n Ն 8) in an industry- year combination in year t, we find another company j, where j  i, among the remaining companies (n Ϫ 1) in the same industry-year combination whose return on assets (ROA jt ) is closest to that of company i (ROA it ). Our performance-matched, modified Jones model-estimated abnormal accruals (PMMJAbnA) for company i in year t are the difference in raw abnormal accruals between companies i and j. After obtaining PMMJAbnA for all companies with required data in the TEJ database during 1999–2004, we keep only company-year observations in our man- datory rotation sample (MROTA) and three benchmark samples (NROTA, MBEFR, and VROTA). Following Myers et al. 2003, we examine the effectiveness of mandatory audit partner rotation in promoting audit quality using the following regression model: Acc ϭ ␣ ϩ ␤ 1 BMK ϩ ␤ 2 Age ϩ ␤ 3 Size ϩ ␤ 4 IndGrw ϩ ␤ 5 CFO ϩ ␤ 6 Big4 ϩ ␤ 7 FTenure ϩ ␧ (2), where Acc ϭ performance-matched abnormal accruals (PMMJAbnA), measured in absolute, positive, and negative values; BMK ϭ a dummy variable equal to 1 if observations are from one of the three benchmark samples (NROTA, MBEFR, or VROTA), and equal to 0 otherwise; Age ϭ number of years since the company was listed; Size ϭ natural logarithm of total assets at the end of the first half of year t; IndGrw ϭ industry growth ϭ by the TEJ industry classification, and t and t Ϫ 1 refer to the first half of years t and t Ϫ 1, respectively; SALES it i 1ϭ N Α SALES it 1Ϫ i 1ϭ N Α ր [...].. .Mandatory Audit Partner Rotation, Audit Quality, and Market Perception 369 CFO ϭ cash from operations from the statement of cash flows for the first half of year t, scaled by total assets at the end of year t Ϫ 1; Big4 ϭ a dummy variable equal to 1 if the auditor is from a Big 4 or Big 5 audit firm, and equal to 0 otherwise;16 and FTenure ϭ audit firm tenure, measured as the... 2003 is that client-specific knowledge and experience, as captured by the length of audit partner or audit firm tenure, CAR Vol 26 No 2 (Summer 2009) Mandatory Audit Partner Rotation, Audit Quality, and Market Perception 375 are essential for auditors to produce a high-quality audit The mean average partner tenure for the MROTA, NROTA, MBEFR, and VROTA samples are 1.506, 2.332, 4.825, and 2.724 years,... Chen, C., C Lin, and Y Lin 2008 Audit partner tenure, audit firm tenure, and discretionary accruals: Does long auditor tenure impair earnings quality? Contemporary Accounting Research 25 (2): 41 5-4 5 CAR Vol 26 No 2 (Summer 2009) 390 Contemporary Accounting Research Chi, W., and H Huang 2005 Discretionary accruals, audit- firm tenure and audit- partner tenure: Empirical evidence from Taiwan Journal of Contemporary... use alternative proxies for audit quality, such as the issuance of goingconcern opinions and incidence of financial restatements, to examine the effect of mandatory partner rotation on audit quality, and alternative proxies for perceived audit quality, such as the cost of capital, to further examine the effect of mandatory partner rotation on perceptions of audit quality Endnotes 1 We use “earnings quality”... first half of year t, scaled by the market value of equity at the beginning of January of year t; ⌬E ϭ change in income from continuing operations between the first half of year t and the first half of year t Ϫ 1, scaled by the market value of equity at the beginning of January of year t; Growth ϭ the sum of market value of equity and book value of total debt divided by book value of total assets, all measured... Second, the audit quality of companies in the mandatory rotation sample under new audit partners is lower than the audit quality of these same companies one year ago under old audit partners Chen et al (2008) document that audit quality is positively related to audit partner tenure under the voluntary rotation regime in Taiwan The essence of Chen et al 2008, Johnson et al 2002, and Myers et al 2003 is... fiveyear partner rotation became de facto mandatory in 2004 Audit reports in Taiwan contain both audit firm and partner names so that researchers can identify years in which audit partners are rotated either voluntarily or mandatorily We first examine the effect of mandatory partner rotation on audit quality, using both absolute and signed abnormal accruals as proxies for audit quality (Johnson et al 2002;... enhances audit quality We then examine the effect of mandatory partner rotation on investor perceptions of audit quality, using the ERC as a proxy for perceived audit quality (Ghosh and Moon 2005) We find that the ERC of companies subject to mandatory partner rotation in 2004 is not significantly different from the ERC of companies not subject CAR Vol 26 No 2 (Summer 2009) Mandatory Audit Partner Rotation, Audit. .. perceive mandatory audit partner rotation as enhancing audit quality We contribute to the literature on auditor tenure and audit quality Mandatory audit partner rotation has existed in the United States since the 1970s and has been recently strengthened by SOX Besides the United States, many other countries also adopt mandatory audit partner rotation as a mechanism to enhance auditor independence and audit. .. audit quality or perceptions of audit quality A limitation of our study is that our inferences about the effectiveness of mandatory partner rotation on audit quality and perceived audit quality critically depend on the ability of our accrual-based proxies (abnormal accruals) and marketbased proxy (ERC) to capture both audit quality and perceived audit quality Although widely used in the accounting literature, . interpreted with caution. Our inferences about the effect of mandatory partner rotation on audit quality and perceptions of audit Mandatory Audit Partner Rotation, Audit Quality, and Market Perception. (Summer 2009) pp. 359–91 © CAAA doi:10.1506/car.26.2.2 Mandatory Audit Partner Rotation, Audit Quality, and Market Perception: Evidence from Taiwan* WUCHUN CHI, National Chengchi University . classification, and t and t Ϫ 1 refer to the first half of years t and t Ϫ 1, respectively; SALES it i 1ϭ N Α SALES it 1Ϫ i 1ϭ N Α ր Mandatory Audit Partner Rotation, Audit Quality, and Market Perception