Evaluating Market-Based Corporate Governance Reform: Evidence from a Structural Analysis of Mandatory Auditor Rotation

Abstract

Many current reform proposals of corporate governance involve financial market intervention as an external governance device. Among them, mandatory audit firm rotation has been controversial. This paper empirically evaluates and quantifies the economic impact of mandatory audit firm rotation using a structural approach, focusing on the critical role played by firms’ existing internal governance. My counterfactual analysis suggests that (1) mandatory audit firm rotation can reduce the shareholder value by 5.9 to 7.2 billion dollars for the US public firm in my sample; (2) a significant fraction of the reduction results from reduced board effectiveness in selecting desirable auditors and hence the policy is more costly to the shareholders of the firms with strong internal governance; (3) policies that improve firm internal governance can work better and increase shareholder value; and (4) mandatory rotation becomes even more costly and further increases the cost of reduced board effectiveness by approximately 4.0 percent when firm internal governance improves and the board interests become fully aligned with shareholder interests. These findings highlight the cost of mandatory audit firm rotation and that the proposed rotation may counteract other policies intended to improve internal corporate governance.