Early Adopters of Mandatory Auditor Rotation and Audit Quality

Abstract

Researchers and regulators have continuously debated whether mandatory audit firm rotation impacts audit quality. Theoretically, rotation might improve auditor independence but impair auditor competence. In 2014, the European Commission mandated audit firm rotation for public-interest entities, starting from 2020 for non-financial firms. However, in the transition period, any auditor change could already be interpreted in light of the upcoming mandatory regime, consistent with anecdotal evidence on such interpretations. These changes provide a unique setting because auditors have strong incentives to build a reputation for high-quality audits when choosing to participate in the market for rotations in the transition period. Using a balanced panel of 287 German firms and data from 2014 to 2019, we hypothesize and find lower discretionary accruals, abnormal working capital accruals, and total accruals in the first year after rotation. This effect is restricted to smaller public companies and does not persist in the following years.