The Auditor Tenure and the Quality of Earnings:
Is Mandatory Auditor Rotation Useful?
This study assesses whether “mandatory auditor rotation” is likely to improve earnings quality and potentially audit quality. The results find that, on average, the mean, median, and standard deviations of accruals are smaller with longer the auditor-client relationship. These results hold controlling for firm age, size, audit firm quality, and period, and are consistent across numerous accruals definitions. Building on previous research that uses accruals to proxy for the quality of earnings, I interpret the results as suggesting that imposing mandatory auditor rotation may have a negative impact on earnings quality. Further, if audit quality is thought of as constraining extreme management decisions in the reporting of financial performance, this results suggest that mandatory rotation may lead to lower audit quality.
Keywords: auditor tenure, earnings quality, audit quality, mandatory rotation
The issue of earnings quality and the quality of financial statements in general has been the focus of recent Indonesia regulatory, and financial statement user discussions. Recent events have focused the public’s eye on the quality of earnings and on auditing quality in general. The ensuing debate over the party responsible for instances of low quality earnings has lead to numerous legislative proposals at the regulator levels. One of the proposal attempts to place limits on the term of a given auditor-client relationship. Our regulator currently in every event suggest that the limit on an auditor’s tenure with a client should be as long as five years for an audit firm. In addition, some large institutional investors are also calling for limits on auditor tenure as a preventative measure (Benson 2002).
Limits on auditor tenure are predicated on the notion that an extended auditor-client relationship allows for auditor complacency about and possibly complicity in the decisions that management makes regarding the presentation of financial results. Advocates of mandatory auditor rotation have explicitly stated the belief that poor quality earnings can be directly associated with the duration of the auditor-client relationship. Poor quality earnings are problematic because they may mislead investors, resulting in the potential for misallocation of resources at a societal level.
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