The Impact of the Auditor Selection Process and Audit Committee Appointment Power on Investment Recommendations

Abstract

After the global 2018 financial crisis, regulatory bodies proposed alternative auditor selection processes to enhance auditor independence such as mandatory audit firm rotation or mandatory tendering (i.e., rotation which allows for the current auditor to be reappointed). However, these alternative selection processes may not be effective if management has substantial influence over auditor appointment decisions. We posit that disclosures of high appointment power of the audit committee will enhance the perceived effectiveness of rotation and tendering, thus, increasing investment recommendations. In an experimental study involving 118 experienced investment professionals, we examine the impact of the auditor selection process (mandatory rotation, mandatory tendering, and voluntary selection) and the appointment power of the audit committee (high, low) on investment recommendations. We find that audit committee appointment power affects investment recommendations only when a possible auditor change is anticipated (i.e., in the case of rotation and tendering), but not when the auditor selection is voluntary. Further, rotation and tendering lead to a higher recommended investment likelihood than voluntary selection, but only when an audit committee has high appointment power. In all, the findings underscore that investors do not view auditor selection processes in isolation of a company’s internal corporate governance mechanisms.

Keywords: audit firm rotation; audit firm tendering; audit firm voluntary selection; audit committee appointment power; investment recommendations, corporate governance

JEL Classification: M42, M48, G11