Estimating a Dynamic Model of Auditor Tenure and Misstatements

Abstract

We estimate an infinite-horizon dynamic oligopoly competition model of audit firm tenure and misstatements and we evaluate a policy counterfactual involving mandatory audit firm rotation. By reducing the value of retaining audit firms, mandatory rotation leads to large increases in auditor switches even before the term limit, implying increases in the switching costs borne by clients. Misstatement rates increase because audit firms endogenously lower the quality of audit services and newly hired audit firms discipline less. Overall, the model suggests caution when evaluating the costs and benefits of government oversight over the audit profession.

Keywords: Structural estimation; auditor tenure; mandatory audit firm rotation; misstatements; conditional choice probabilities; dynamic discrete choice

JEL Classification: K00, C13, M4