The Effects of Mandatory Audit Firm Rotation on Client Importance and Audit Industry Concentration

Abstract

ABSTRACT Recently, a system of audit firm rotation has been implemented for the audits of listed companies conducted in the European Union (EU). In the U.S., in contrast, the regulator decided against such rotation. Whereas proponents argue that rotation would strengthen independence and decrease audit market concentration, opponents stress the importance of auditors' learning effects, which would be eliminated by a change in auditors. In extending the market matching model of Salop (1979), we provide an analysis that integrates these contradictory views. We assume that both auditors' industry expertise and their experience in auditing a client decrease audit costs. We investigate the bidding strategies applied to re-acquire clients that were lost due to rotation, auditors' profit contributions, the equilibrium number of auditors (i.e., audit market concentration), and the economic importance of specific clients. Our findings indicate that the regulators' goals of simultaneously decreasing client importance and audit market concentration are in direct conflict and, therefore, the rotation system might have unintended consequences. Our model, thus, suggests how different institutional parameters give rise to economic forces that can support diverging decisions regarding the implementation of MAR.