On the Optimal Year of Auditor Rotation

Abstract

We develop a dynamic model to study how audit quality varies with auditor firm tenure under mandatory rotation. In the model, an audit firm is responsible for monitoring financial condition of a company and reports any material misstatements. Two effects influence the audit quality over time. First, the audit firm acquires more specific knowledge about the audited company and thus, the audit quality improves over time. Second, the auditor and the audited company are often engaged in other kinds of business which may lower the audit independence and quality because the audit firm has lower incentive to report potential material misstatements. We show that, under some conditions, audit quality first increases and then decreases over tenure year. Thus, a regulator’s decision on the optimal rotation year involves a dynamic consideration: an early rotation may not fully utilize the benefit from the accumulated company specific knowledge by the current auditor while a late rotation may endure significant loss from a long period of low audit quality due to a late start on duty by a new auditor. We characterize the optimal rotation year and show it should be set when audit quality starts to decline but not too low yet. In addition, the optimal rotation year should vary across industries (countries) and auditors’capabilities. Specially, it should be longer when the legal liability is larger or reputation is more prominent. These findings are consistent with the view that longer tenure years should be granted for industries (countries) with more strict regulations or bigger audit firms that are expected to have higher audit capabilities.