Improving Auditor Independence Through Selective Mandatory Rotation

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 analyse 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 have now have become sufficiently thin to warrant the introduction of rotation.

JEL Classification: G39, M49