Mandatory Audit Firm Rotation: the Best Quality Comes with the Last Term
A new study in the Italian setting shows that, when Mandatory Audit Rotation is implemented, audit quality tends to be lower in the first and second three-year periods compared to the third term (the last one). This happens because the audit firm has incentives to be reappointed at the end of the first two periods, while at the end of the last (i.e. third) three-year term it has to be changed.
Mara Cameran, Annalisa Prencipe (Department of Accounting), and Marco Trombetta (IE Business School, Madrid) published Mandatory Audit Firm Rotation and Audit Quality in European Accounting Review (published on line on June 2014, DOI:10.1080/09638180.2014.921446).
The introduction of the Mandatory Audit Rotation (MAR) is a relevant issue both in Europe and in the United States. The MAR sets a limit on the maximum number of years an audit firm can audit a company's financial statements. This rule has been proposed in order to preserve the auditor independence and to increase the investor confidence in audited financial reports. However, univocal evidence supporting the introduction of MAR is still missing to date.
The authors of this study decided to investigate the effects of mandatory audit firm rotation on audit quality on the unique Italian institutional setting. In Italy a MAR policy has been effective for more than 25 years, thus providing a real MAR context. The main strength of the paper is indeed the fact that the analysis is carried out in a real rotation setting, where the incentives of the auditor may be affected by potential future re-appointments. In a voluntary rotation setting there is no limit to future reappointments, so the auditor incentives are not likely to change as the maximum limit approaches. Only a mandatory setting (such as the Italian one) allows to observe a change in auditor incentives and to check how the auditor behavior is affected. The Authors hypothesize and find that audit quality tends to be lower in the first two three-year periods. In particular, using accounting conservatism as a proxy for audit quality the Authors show that auditors become more conservative (i.e. audit quality is higher) in the third year period (i.e. the last one) compared to the previous two. This happens because in the last period the audit firm cannot be reappointed and possible litigation issues become more relevant. Moreover, the study documents that the investor perception of the audit quality tends to improve as the final engagement period gets closer.
Overall, these findings contribute to our understanding of actual and perceived audit quality in a real mandatory audit rotation setting. The study provides useful evidence for regulators interested in evaluating the costs and benefits related to the implementation of a MAR requirement.