The Consequences of Mandating Auditor Rotation: Evidence from a Dynamic Structural Model

Abstract

We construct a dynamic discrete choice model, in which clients choose in each period to retain or replace their incumbent auditor, and whether to misstate or not their financial information, based upon past auditor tenure, auditor size, and prior year misstatement choices. Using the conditional choice probability framework, we estimate the model and evaluate the impact of introducing mandatory auditor rotation. Our counterfactual analysis predicts that the long-run misstatement rate diminishes by 1.5 (0.8) percentage points with a 5-year rotation rule (10-year rotation rule) from 4.6 percentage points in absence of mandatory rotation. Mandatory rotation is accompanied by larger switching rates in particular from a Big 4 to a non Big 4 auditor, which result in a drop in the Big 4 market share from 65% to 30% (42%) under a 5-year rotation rule (10-year rotation rule). Our results suggest that mandatory auditor rotation, through clients' forward-looking behavior, can change audit market competition and discipline clients in maintaining clean financial information.

Keywords: auditing, structural estimation, conditional choice probabilities

JEL Classification: K00, C13, M4