Improving Auditor Independence Through Selective Mandatory Rotation

Abstract

When an auditor receives significant fee income from one client it has often been suggested that reappointment concerns may dilute auditors incentives to maintain independence from management. A possible response to this issue could be to mandate the rotation of auditors. However this is costly since new auditors must repeatedly invest in learning a new clients accounting system. In this research we build a model to formally analyze this trade‐off. We find that the desirability of rotation depends critically upon characteristics of the audit market structure and to what extent an individual client dominates an auditors’ client portfolio defined in terms of total fees. We show that although rotation is costly, in audit markets with relatively few large clients (thin markets), the resulting improved incentives for independence outweigh the associated costs. Our research is timely because although historically it may not have been economically desirable to adopt mandatory rotation, currently with increased corporate merger activity taking place, for instance in the oil sector, markets may now have become sufficiently thin to warrant the introduction of rotation.

The influence of auditor term length and term limits on US state general obligation bond ratings

“…Such a mechanism suggests that term limits make it possible for policymakers to actually implement welfare improving 3 Note that this discussion focuses on actual tenure and not official term length. Recent contributions are e.g., Dopuch et al (2001), Gietzmann and Sen (2002), Johnson et al (2002), Myers et al (2003), Mansi et al (2004), Comunale and Sexton (2005), and Gosh and Moon (2005). 4 Furthermore, it is often suggested that extended client-auditor relationships alone impede on auditor independence due to evolving ties between auditor and client (e.g., Mautz and Sharaf 1961).This argument is underlined by psychological evidence showing that with closer ties between client and auditor psychological bias grows stronger (Bazerman et al 2002).…”

Mandatory audit firm rotation: Fresh look versus poor knowledge

“…In contrast, we focus on auditor biases and employ a one-period framework. Gietzmann and Sen (2002) (hereafter, GS) find that MAR should only be imposed in thin markets where a few clients dominate the auditor's client portfolio, whereas we find that the desirability of 1 We thank an anonymous referee for pointing out this argument on the market's beliefs under MAR. MAR depends on the client prospect and the auditor bias.…”

Auditors perceptions on impact of mandatory audit firm rotation on auditor independence Evidence from Bahrain

“…Gietzmann and Sen (2002) studied the tradeoff between the concerns of the auditors to be reappointed by the client and the costs that mandatory rotation rule implies. In other terms, the auditor receiving high fees from the client is interested in a renewal of the engagement and this can impair the auditor's incentive to be independent.…”