Mandatory Auditor Rotation, Audit Fees and Audit Quality

In this paper we examine some of the costs and benefits associated with mandatory audit firm rotation using data from Italy, where mandatory audit firm rotation has been in place since 1975. Previous studies on the subject did not find consistent evidence on the association between audit quality and mandatory audit firm rotation, and they fail to control for auditor fees. In this paper, we test whether there is a change in audit quality associated with mandatory audit firm rotation after controlling for audit fees. Further, we test whether there is a change in auditor fees associated with mandatory audit firm rotation. Our results indicate that audit quality, proxied by two different measures of earnings management, improves following mandatory audit firm rotation and this improvement is driven by higher negative (income decreasing) abnormal accruals. Our results also indicate that the total amount of fees paid to the auditor does not change following mandatory audit firm rotation, but the composition of total fees paid to the auditor (audit vs. non audit fees) does appear to change, with audit-related fees increasing as a percent of total fees. The results of this study might be of interest to U.S. and European legislators who are considering implementing mandatory auditor rotation in order to improve financial reporting quality.