Auditors and Corporate Governance: Evidence from the Public Sector

Abstract

Corporate auditors review financial statements and evaluate the accuracy of the provided information. Several institutional details such as selection mechanisms and auditor tenure length are important for independence. New corporate governance rules require board committees appointing the auditor to be more independent from management. In order to enhance independence, provisions calling for mandatory auditor rotation have been debated intensively, but the available empirical evidence is not conclusive. We review the literature and argue that the available empirical evidence on auditor rotation in the corporate sector suffers from serious problems of endogeneity. We propose learning from the public sector in which auditors play a similar role. We present empirical evidence on the impact of auditor term length and rotation requirements on government performance at the US State level. We find a quadratic relationship between auditor term length and state credit ratings. This implies that auditor performance is weaker in the beginning of a mandate as well as in extended auditor-client relationships. Furthermore, in States that adopted term limits for auditors our evidence suggests beneficial effects of mandatory auditor rotation.

Keywords: corporate governance, auditor, mandatory auditor rotation, public auditor

JEL Classification: G30, G34, M49