How Do Various Forms of Auditor Rotation Affect

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The International Journal of Accounting 47 (2012) 109 – 138

How Do Various Forms of Auditor Rotation Affect Audit Quality? Evidence from China☆ Michael Firth a , Oliver M. Rui b,⁎, Xi Wu c
c

Department of Finance and Insurance, Lingnan University, Hong Kong b China Europe International Business School, China School of Accountancy, Central University of Finance and Economics, China Received 8 June 2010

a

Abstract The Enron/Arthur Andersen scandal has raised concerns internationally about auditor independence, audit quality, and the need for regulatory action such as mandatory auditor rotation. China's unique institutional features provide a setting in which we can compare comprehensively the various forms of auditor rotation at different levels (partner vs. firm) and in different settings (voluntary vs. mandatory). In addition, institutional conditions vary dramatically across China, which provides us with an opportunity to test whether the development of market and legal institutions affects the impact of rotation on audit quality. We expect that auditors are less (more) constrained by market forces and less (more) self-disciplined to maintain audit quality in regions with less (more) developed market and legal institutions. Therefore, mandatory rotation may play a more (less) important role in less (more) developed regions. Using auditors' propensity to issue a modified audit opinion (MAO) as a proxy for audit quality, we find that firms with mandatory audit partner rotations are associated with a significantly higher likelihood of an MAO than are no-rotation firms. However, this effect is restricted to firms located in less developed regions. We find similar evidence for voluntary audit firm rotation although the significance level is much weaker than for mandatory partner

☆ We appreciate the very helpful comments and suggestions of Rashad Abdel-khalik (Editor), Roger Simnett (Co-Editor), three anonymous reviewers, Chee Chow, Mark DeFond, and T. J. Wong. Michael Firth acknowledges financial support from the Government of the HKSAR (GRF340408). Oliver Rui acknowledges financial support from the Government of the HKSAR (CUHK450009). Xi Wu acknowledges financial support from the National Natural Science Foundation of China (No. 70602020), the Program for Innovation Research at the Central University of Finance and Economics (CUFE), the Beijing Municipal Commission of Education “Joint Construction Project”, and the “Project 211” Fund of CUFE. ⁎ Corresponding author. E-mail addresses: mafirth@ln.edu.hk (M. Firth), oliver@ceibs.edu (O.M. Rui), wuxi@cufe.edu.cn (X. Wu).

0020-7063/$ - see front matter © 2012 University of Illinois. All rights reserved. doi:10.1016/j.intacc.2011.12.006

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M. Firth et al. / The International Journal of Accounting 47 (2012) 109–138

rotation. Other forms of auditor rotations (i.e., mandatory audit firm rotation and voluntary audit partner rotation), have no effect on MAOs. © 2012 University of Illinois. All rights reserved. Keywords: Mandatory audit partner rotation; Mandatory audit firm rotation; Voluntary rotation; Market and legal institutions; Modified audit opinion

1. Introduction This paper examines how various forms of auditor rotation (partner level vs. firm level; mandatory vs. voluntary) affect audit quality in the Chinese capital market setting. The collapse of Enron and its auditor, Arthur Andersen, quickly led regulators worldwide to consider different mechanisms for enhancing auditor independence. Legislators, regulators, and professional organizations around the world have suggested mandatory auditor rotation at both the partner and the firm level as a potential means to reduce client–auditor familiarity and introduce fresh perspectives, thereby enhancing auditor independence and audit quality (e.g., General Accounting Office (GAO), 2003). The typical counterarguments for this suggestion are that auditors have economic...
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