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 information 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 partner rotation on earnings quality or audit quality.' In this paper, we use audit data in Taiwan, where a five-year audit partner rotation 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 Contemporary Accounting Research Conference, generously supported by the Canadian Institute of Chartered Accountants, the Certified General Accountants of Ontario, the Certified Management 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 University. Professor Chi gratefully acknowledges the financial support from National Science Council (NSC 93-2416-H-004-036). Contemporary Accounting Research Vol. 26 No. 2 (Sumtner 2009) pp. 3 5 9 - 9 1 © CAAA doi:10.1506/car.26.2.2
Contemporary Accounting Research
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 Joumal (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 refiect 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 mandatory rotation sample) and compare it with three benchmark samples,^...