Abstract
Credible audit quality is a precondition for a firm’s sustainability. External auditors offer assurance with regard to the uncertain factors that can jeopardize a firm’s sustainability and provide audit opinions that help investors assess risk. After the global crisis and accounting scandals, mandatory audit firm rotation has been implemented globally. However, few studies have investigated either the cost or the benefit of mandatory audit firm rotation. Prior studies provide only indirect evidence on the effects of audit firm tenure on audit quality/perceived audit quality. By discussing prior arguments, we examine how investors perceive the implementation of mandatory audit firm rotation in Korea. Using a unique and direct setting to examine our research question, we analyze the relationship between firms with mandatorily switched audit firms and the cost of equity capital from 2006 to 2008. We find that the mandatory change in the auditors has a negative association with the cost of equity capital. The results are robust to using the arithmetic mean of the cost of equity capital, lagged control variables, and the manufacturing industry effect. The results indicate that investors perceive that mandatory audit firm rotation provides an environment for qualified audits by enhancing auditor independence and skepticism, and thus decreases the cost of equity capital. This study helps to improve our understanding of the impact of mandatory audit firm rotation the information risk evaluations and provides political implications for policy makers by showing the benefit of mandatory audit firm rotation.
Highlights
The separation of ownership and management induces information asymmetry between management and market participants and creates a conflict of interest among market participants [1]
In contrast to Boone et al [20], who find that the cost of equity capital decreases with audit firm tenure, we find clear evidence that mandatory audit firm rotation matters to investors and leads to a lower cost of equity capital
The dependent variables, which measure the cost of equity capital, include the Price-Earnings-Growth model (PEG), MPEG, GM, and MR
Summary
The separation of ownership and management induces information asymmetry between management and market participants and creates a conflict of interest among market participants [1]. High audit quality is a precondition for reducing information asymmetry and enhancing the credibility of accounting information. An audit with lower value relevance (due to an audit failure caused by lower auditor independence) hinders proper resource allocation in the capital market and would jeopardize a firm’s sustainability. The Enron scandal clearly shows how auditor independence affects a firm’s sustainability. Enron’s stakeholders expressed doubts about Arthur Andersen’s independence when Enron restated its profits for 1997 through 2000, because Enron was one of his big clients. Their relationship of 16 years was too long [4]. Most countries consider the systematic improvement of audit quality by enhancing audit firm/auditor independence. In addition to institutional movements, prior literature in accounting field has focused on the circumstances that jeopardize auditor independence, such as long auditor tenure, close relationships between auditor and management, and economic dependency
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