The Anticipation of Mandatory Audit Firm Rotation and Audit Quality

Abstract

Researchers and regulators regularly debate whether mandatory audit firm rotation affects audit quality. Theoretically, rotation might improve auditor independence but impair competence. In 2014, the European Commission mandated audit firm rotation for public-interest entities, starting from 2020 for nonfinancial firms. However, any auditor change in the transition period could already be interpreted in light of the upcoming mandatory rotation regime, consistent with anecdotal evidence on such interpretations. These changes provide a unique setting because auditors have strong incentives to build a reputation for high-quality audits when choosing to participate in the market for rotations during the transition period. Using a balanced panel of 287 German firms and data from 2014 through 2019, we hypothesize and find lower discretionary accruals, abnormal working capital accruals, and total accruals in the first year after rotation. This effect is restricted to smaller public companies. Data Availability: The data are from public sources and are available from the third author upon written request. JEL Classifications: M42; M48.