Does Mandatory Rotation of Audit Partners Improve Audit Quality?

A China’s study by CUHK Business School shows that the mandatory rotation of audit partners can enhance audit quality

By Huang Hong, PhD Candidate, School of Accountancy, CUHK Business School

Audit plays a significant role in the capital market. High-quality audit reduces the risks of inaccurate information, increases the transparency of the audited entities and thus facilitates financing and investment.

Because of such critical function of high-quality audit, many countries and jurisdictions around the world have established and enforced stringent regulations toward audit practice. One example of these regulations is imposing limitations on the length of audit partner tenure.

Regulators believe that forcing companies to change audit partner every few years can bring in fresh perspectives from new auditors who can be more independent and capable of discovering errors in financial reporting.

However, it is difficult to gather available data to test the efficiency of such approach due to the fact that most countries do not require audit partners’ names to be disclosed and so researchers are unable to identify any partner rotations – except in a few jurisdictions including China.

“In China, audit reports also need to disclose the names of both the review partner and engagement partner. Unless there is contrary evidence, the two partners sharing the same legal liability are subject to the same rules on mandatory rotation,” says Prof. Tianyu Zhang, Director of Center for Institutions and Governance at CUHK Business School.

In collaboration with Prof. Clive S. Lennox at Nanyang Technological University and Prof. Xi Wu at Central University of Finance and Economics, Prof. Zhang’s study entitled “Does Mandatory Rotation of Audit Partners Improve Audit Quality?” confirms that mandatory rotations of audit partners improve audit quality of the firm.

“Our result is significant as many countries rely on mandatory audit partner rotation rather than mandatory audit firm rotation to ensure high-quality audit,” says Prof. Zhang.

Unique Datasets in Chinese Audit Market

China is among the countries and jurisdictions which adopt a mandatory rotation of audit partners. Under Articles 3 and 5 issued by the China Securities Regulatory Commission (CSRC) and the Ministry of Finance dated October 8, 2003, the review and engagement partners have to be rotated every five years or in the case of newly listed companies, at the end of the second year following the initial public offering (IPO).

In China, audit reports also need to disclose the names of both the review partner and engagement partner. (Other jurisdictions currently requiring the disclosure of individual auditors include Australia, Taiwan, Germany, Sweden, Finland, Japan, and the UK.) Unless there is contrary evidence, the two partners sharing the same legal liability are subject to the same rules on mandatory rotation. Moreover, since 2006, for every public company audit in China, the audit firm is required to report the company’s pre-audit earnings to the Ministry of Finance. Using the pre-audit earnings number, the Inspection Bureau of the Ministry of Finance can identify whether a company had an audit adjustment to its earnings number.

“Audit adjustments are indications that an existing misstatement in financial reports is discovered and then corrected by the auditor. In other words, the existence of the audit adjustments in a certain audit engagement shows that auditors have delivered high-quality audit practice,” says Prof. Zhang.

“A newly appointed partner may have less client-specific knowledge and, therefore, be less likely to find financial reporting problems.”

Prof. Zhang Tianyu

How Does Mandatory Audit Partner Rotation Impact Audit Quality?

Proponents of mandatory rotation of audit partners believe that it can enhance the audit quality by providing an effective peer review effect. For example, the American Institute of Certified Public Accountants (AICPA) in the US and the Cadbury Committee in the UK believe that a replacement partner could bring in a fresh perspective to the audit and is therefore more likely to detect and correct financial reporting problems.

If an incoming partner finds the audit in the prior year unsatisfactory, he may inform others in the audit firm and thus damage the reputation of the departing partner within the audit firm, thus creating pressure for the departing partner. The departing partner will make necessary adjustments in his final year of tenure because, otherwise, the replacement partner may find reporting problems carrying over from the previous year.

Some also believe that a newly appointed partner will be more independent of the client as he or she would have had time to develop a close personal relationship with the management after a prolong period and become unwilling to challenge its reporting, creating “a familiarity threat” as claimed by the Code of Ethics of the International Federation of Accountants (IFAC).

However, this independence effect could be compromised, thus weakening the beneficial impact of mandatory rotation of audit partner.

“A newly appointed partner may have less client-specific knowledge and, therefore, be less likely to find financial reporting problems,” says Prof. Zhang.

Findings

Using a final sample of 6341 company-year observations for the period of 2006-2010, the study indicates that mandatory rotation results in higher audit quality.

First, an engagement partner is more likely to require an audit adjustment when the partner is scheduled for mandatory rotation at the end of the year.

“This suggests that the departing engagement partner has the motivation to clean up the client’s financial statements before handling over the audit to the new partner. This is consistent with a positive peer review benefit, whereby engagement partners perform higher quality audits when they are scheduled for mandatory rotation,” says Prof. Zhang.

Secondly, the study shows that a newly appointed engagement partner is more likely to require an adjustment during the first year of tenure following mandatory rotation.

“This shows that newly appointed engagement partners do bring in a fresh perspective to the audit and identify more financial reporting problems.”

“Our findings have important implications for public policy because many countries rely on mandatory audit partner rotation rather than mandatory audit firm rotation to ensure high-quality audit,” he says.