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We examine how the last year of an audit engagement (“terminal year”) affects audit quality. We find that auditors are more likely to charge higher audit fees and issue going concern opinions during the final years of their audits suggesting that auditors have higher bargaining power than their clients when the auditors are being replaced. However, these increased costs to companies do not necessarily result in higher audit quality. We find that companies are more likely to have future restatements of the financial statements during the final years of the auditor-client relationships indicating that auditors seem to invest lower quality of effort and resources in the terminal years of audit engagements. Overall, our results suggest that companies could face real economic costs from an auditor being replaced in addition to the start up costs of hiring a new auditor. These results have relevance for the current debate regarding mandatory audit firm rotation by the PCAOB, European Commission and the United Kingdom Competition Commission.
Jagadison K Aier, George Mason University
Keith Jones, George Mason University
Joseph H Schroeder, Indiana University Bloomington