Improving Auditor Independence Through Selective Mandatory Rotation

Authors


  • Miles B. Gietzmann is Professor of Accounting in the Economics Department of the University of Bristol. He has researched several issues around auditors' independence. An earlier paper in this journal was co-authored by him on Auditor Performance, Implicit Guarantees, and the Valuation of Legal Liability; Vol 1, No. 1.

  • Pradyot K. Sen received his PhD from Columbia University and has been in the accounting faculty of University of California Berkeley and SUNY-Buffalo prior to joining the University of Cincinnati. His research interests are in the area of information asymmetry models in financial disclosure, managerial accounting and auditing. An earlier paper in this journal, co-authored by him, was ‘Is Auditor Moral Hazard the Only Reason to Ban Contingent Fees for Audit Services?’ Vol. 1, No. 3.

Department of Economics, University of Bristol, 8 Woodlands Road, Bristol, BS8 1TN. E-mail: m.gietzmann@bristol.ac.uk

Abstract

When an auditor receives significant fee income from one client it has often been suggested that reappointment concerns may dilute auditors incentives to maintain independence from management. A possible response to this issue could be to mandate the rotation of auditors. However this is costly since new auditors must repeatedly invest in learning a new clients accounting system. In this research we build a model to formally analyze this trade-off. We find that the desirability of rotation depends critically upon characteristics of the audit market structure and to what extent an individual client dominates an auditors’ client portfolio defined in terms of total fees. We show that although rotation is costly, in audit markets with relatively few large clients (thin markets), the resulting improved incentives for independence outweigh the associated costs. Our research is timely because although historically it may not have been economically desirable to adopt mandatory rotation, currently with increased corporate merger activity taking place, for instance in the oil sector, markets may now have become sufficiently thin to warrant the introduction of rotation.

Ancillary