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Mandatory Auditor Rotation: Evidence from the Italian Experience

Sat, January 19, 3:45 to 5:15pm, TBA

Abstract

Mandatory rotation was recently proposed for the European Union and is also under consideration in the United States. This regulation would create a radical change in the audit market, yet there has been little rigorous published research into either the benefits or costs of rotation that could inform intelligent policy making. Our paper helps fill this gap by examining Italy where mandatory rotation of auditors has been required since 1975. A unique feature of the study is proprietary data on audit engagement hours and audit fees provided to us by the Big 4 accounting firms which is used to estimate incremental audit costs of mandatory rotation during the sample period 2006-2009. Outgoing auditors do not shirk on effort (or quality), but we do find that final year fees are 6 percent higher than normal which suggest some price gouging. Incoming auditors have more engagement hours in the first year (16 percent), but fees are discounted by 8 percent, suggesting a lowballing amount of 24 percent. However, this amount is recovered through abnormally higher fees in the future. Thus the direct cost of mandatory rotation appears to be small in Italy. An implicit cost of rotation occurs if there is a decline in the quality of audited earnings around the rotation event, and we find evidence of lower quality audited earnings in the first three years following rotation, relative to later years of auditor tenure. Since the quality of audited earnings improves with auditor tenure, the evidence does not support the case for mandatory rotation as rotation will induce more “short tenure” audits.

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