Costs of Mandatory Periodic Audit Partner Rotation: Evidence from Audit Fees and Audit Timeliness

Abstract

SUMMARY The constricted mandatory audit partner rotation rules for U.S. public companies have fueled intense debate among the profession, regulators, and policymakers. This topic remains controversial, but neither side has provided evidence of the consequential benefits and costs of mandatory rotation. While rotation effects on audit quality have been examined, we empirically examine its effects on two audit production costs: audit fees and audit timeliness. We find significantly higher audit fees and significantly longer audit report lags in the period immediately following mandatory audit partner rotation. These effects are more pronounced for non-Big 4 auditors, larger clients, and audit offices that are not industry specialists. Moreover, the audit fee and audit timeliness effects persist in successive audit partner rotations, suggesting that client-specific knowledge gained through longer audit firm engagement does not completely mitigate loss of client-specific knowledge at the partner level. Our findings provide new empirical evidence supporting the profession's arguments that mandatory audit partner rotation is costly to multiple stakeholders, including clients, auditors, and investors. Data Availability: All data are publicly available from sources identified in the text.

Interim reviews and the association between partner rotations and audit fees

“…As we find evidence of significantly higher (lower) fees for rotations at the interim review (annual audit), our audit reporting lag results suggest that this is not driven by differential audit effort or the audit partner identifying issues that require more work at the annual report audit (i.e., the costs of partner rotation) but rather differences in bargaining power when rotations are either planned or unplanned. This finding expands on Sharma et al () by showing that planned rotations occurring at the interim review allows for timelier audit reporting at the annual report.…”

“…When including LFTEN , we find the variable is not significantly associated with audit fees. The results do not change when we interact LFTEN with Rotation , RotationReview , or RotationAudit , and as all interaction terms are insignificant this suggests that familiarity between the audit firm and client does not mitigate the pricing effects of rotation (Sharma et al, ). Our results also do not differ when using the natural logarithm of audit firm tenure.…”

“…We consider whether there are different audit fees in the two years before and after rotations before the interim review and annual report audit (Sharma et al, ; Stewart et al, ). We find that neither the two years prior nor the two years following rotation are associated with audit fees and our primary variables of interest remain qualitatively the same suggesting these effects are rotation year specific.…”

“…Ferguson et al () also find a greater increase in audit fees for mandatory partner rotations in Australia, and emphasize that the supply‐side costs for partner rotation would be greater for smaller audit firms. Using US data, Sharma et al () document higher audit fees after partner rotations, and that the effect is stronger for clients of non‐Big 4 auditors.…”

“…We also consider the effect of mandatory partner rotation, of which almost exclusively occurs at the interim review, and find higher audit fees for mandatory partner rotations involving non‐Big 4 auditors (Ferguson et al, ; Sharma et al, ).…”