Abstract
This paper estimates a dynamic model of clients' decisions to switch audit firm and misstate earnings as a function of auditor tenure. Adapting the conditional choice probability framework of Hotz and Miller (1993), which simplifies the estimation to a conditional logit, we find that dynamic considerations are important for clients' audit firm switching decisions. We then use the model to evaluate a policy counterfactual of mandatory audit firm rotation that reduces the expected horizon with an audit firm. We find that mandatory rotation reduces misstatement rates by about 1 to 3 percentage points but leads to large increases in auditor switches, even before the term limit. Estimating how mandatory rotation may alter auditor effort reveals a significant reduction in effort but does not materially change our main findings. Overall, the results call for caution when evaluating the benefits of mandatory audit firm rotation.
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