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MAJ
23,5

Mandatory audit firm rotation

and audit quality

420

School of Accounting, The University of New South Wales, Sydney, Australia

Andrew B. Jackson
Michael Moldrich
KPMG, Sydney, Australia, and

Peter Roebuck
School of Accounting, The University of New South Wales, Sydney, Australia
Abstract
Purpose The purpose of this paper is to investigate the effect that a regime of mandatory audit firm
rotation would have on audit quality.
Design/methodology/approach Using two measures of audit quality, being the propensity to
issue a going-concern report and the level of discretionary accruals, the paper examines the switching
patterns of clients in their current voluntary switching capacity, and the levels of audit quality.
Findings The main finding is that audit quality increases with audit firm tenure, when proxied by
the propensity to issue a going-concern opinion, and is unaffected when proxied by the level of
discretionary expenses. Given the additional costs associated with switching auditors, it is concluded
that there are minimal, if any, benefits of mandatory audit firm rotation.
Research limitations/implications A limitation of this study is that only actual audit quality is
examined. While the results suggest that actual audit quality is associated with the length of audit
tenure, the perception of audit quality is not addressed, which may increase with audit firm rotation.
Originality/value The results go against the move towards mandatory audit firm rotation, and
suggest that other initiatives may need to be considered to address concerns about auditor
independence and audit quality.
Keywords Auditing, Auditors, Laws and legislation, Australia
Paper type Research paper

Introduction
Considerable research has examined the effect that the length of the auditor-client tenure
has had on audit quality, but commonly fails to consider the financial characteristics of
clients in the years preceding a switch. This study examines the financial attributes of
clients in the years preceding and succeeding an audit firm switch, as well as voluntary
auditor switching behaviour to determine whether such auditor movements would be
favourable under a scheme of mandatory rotation. The ability of the top-tier audit firms
and industry-specialists to provide consistently high levels of audit quality is also studied.

Managerial Auditing Journal

Vol. 23 No. 5, 2008
pp. 420-437
q Emerald Group Publishing Limited
0268-6902
DOI 10.1108/02686900810875271

The views expressed in this paper are not necessarily the views of KPMG.
Financial assistance for this study was kindly provided by the Capital Markets and
Co-operative Research Centre and the Australian School of Business, UNSW. The authors would
also like to acknowledge the helpful comments of participants at the 2005 Faculty of Commerce
and Economics UNSW National Honours Colloquium, Liz Carson, Jeff Coulton, Asher Curtis,
Rob Czernkowski, Andrew Ferguson, Gerry Gallery, Caitlin Ruddock, Roger Simnett,
Stephen Taylor, and two anonymous reviewers. All errors remain the authors responsibility.

Following recent legislative changes imposed on the auditing profession through

the introduction of the Corporate Law Economic Reform Program (Audit Reform &
Corporate Disclosure) Act 1999 (CLERP 9), there is a need to determine whether the
current regulations are enough, or whether further regulatory changes, such as a
system of mandatory audit firm rotation, are desirable. There has also been a call for
further research on this topic by both the international standard setters and academics
(Government Accountability Office GAO, 2003; Nagy, 2005). This study is further
motivated by a lack of research examining characteristics of the client in the years
prior to the audit firm switch, which may have an impact on subsequent audit quality.
The aim of this study is to understand whether the clients financial characteristics
under the predecessor auditor have an impact on audit quality under the incumbent
auditor. An additional aim is to determine whether current voluntary switching
patterns would be conducive to a system of forced rotation, and whether the top-tier
audit firms and industry specialists are able to provide higher levels of audit quality
over a period of time.
We find that audit quality increases with audit firm tenure, when proxied by the
propensity to issue a going-concern opinion, and is unaffected when proxied by the
level of discretionary accruals (DA). Given our results, we conclude that mandatory
audit firm rotation will not improve audit quality. Considering the costs involved
during the early stages of an auditor-client relationship, requiring firms to rotate their
auditors will place unnecessary costs on both the auditor and the client with minimal
benefits. In order to address concerns that have arisen surrounding auditor
independence issues, we conclude that other initiatives are more likely to have a
greater impact than mandatory audit firm rotation.
Background and empirical predictions
Audit firm rotation
A system of mandatory audit firm rotation would require companies to rotate their
independent auditor periodically. Currently, listed companies in Italy and Brazil are
required to rotate their independent auditor every nine and five years, respectively. In
Australia, there is currently no legislative requirement for reporting entities to rotate
their independent audit firm, although periodic rotation of lead audit partners is now
obligatory under s324DA of the Corporations Act 2001 (Cth).
Advocates of audit firm rotation believe a scheme of compulsory rotation would
prevent auditors from becoming too aligned with managers, impacting on their
independence. A client may be a significant source of revenue for an auditor, and the
auditor may be reluctant to jeopardise this revenue stream (Hoyle, 1978). Firm rotation
may also help to prevent large-scale corporate collapses. Morgan Stanley estimates the
market capitalisation loss of the collapses of WorldCom, Tyco, Quest, Enron and
Computer Associates to be $US460 billion. Firm rotation can help restore confidence in
the regulatory system, which was found to be the case in Italy (Healey and Kim, 2003).
Further, if a client seeks a new auditor, auditors will compete with other audit firms to
win the tender and differentiate themselves in terms of service, improving audit quality
(Hoyle, 1978). Despite the increased start-up costs which are involved with introducing
a new auditor, supporters of audit firm rotation propose that the costs of corporate
collapses, which may not have occurred had audit quality been higher, outweigh the
increase in audit costs involved when introducing a new auditor. From this

Audit firm
rotation and
audit quality
421

MAJ
23,5

422

perspective, a new auditor brings in more objectivity as they are not familiar with the
client, potentially improving the quality of the audit.
On the contrary, mandating firm rotation would lead to a loss of client knowledge
when the auditor is forced to resign. Auditors experience a significant learning curve
with new clients (Knapp, 1991), and much of the knowledge acquired during an audit is
client-specific (Kinney and McDaniel, 1996). Audit failures are generally higher in the
first years of the auditor-client relationship as the new auditor becomes familiar with
the clients operations (Arel et al., 2005). Audit costs would also rise due to the
additional work needed by the new audit firm. The GAO (2003) estimated that
companies would incur additional auditor selection costs equal to 17 per cent of their
first year audit fees (GAO, 2003). Opportunity costs would also arise because of a
mismatch between the clients needs and those which the auditor can offer (Arrunada
and Paz-Ares, 1997). Auditor resignations provide valuable signals to the market
(Wells and Loudder, 1997). Under mandatory rotation, if a client is experiencing
conflicts with its auditor over accounting treatments and the auditor is forced to rotate,
the market misses out on valuable signals that would have taken place under
voluntary rotation. The largest accounting firms may also increase their market share
under mandatory rotation, as has been the case in Italy (Buck and Michaels, 2005),
leading to a less-competitive environment.
Even if research has generally not found significant positive effects of firm rotation
on audit quality, rotation may nevertheless be effective in increasing perceived
audit quality. Audit quality comprises actual and perceived quality (Taylor, 2005).
Actual quality is the degree to which the risk of reporting a material error in the
financial accounts is reduced, while perceived quality is how effective users of financial
statements believe the auditor is at reducing material misstatements. Higher perceived
audit quality may then help promote investment in audited clients.
Related literature and empirical predictions
It has been argued that companies switch auditors to avoid receiving qualified audit
reports. This argument assumes that managers dislike qualified reports and that
managers influence the appointment decision.
The first assumption is relatively uncontroversial. A qualified report may signal to
investors that managers are poor stewards of the companys affairs, or that managers
have attempted to present an over-favourable view of the companys performance
and/or position. In addition, qualified reports cause share prices to fall, reducing
managerial utility if managers own shares or if their compensation is directly related to
market value (Firth, 1978; Banks and Kinney, 1982; Fleak and Wilson, 1994; Chen and
Church, 1996; Jones, 1996).
The second assumption is more controversial. By law in Australia, auditors are
appointed by shareholders. However, managers may exert considerable influence over
auditor appointments. Incumbent auditors could be dismissed by managers without
consulting shareholders, with the shareholders merely voting on whether to accept
their recommendation regarding the appointment of a new auditor or the
re-appointment of the incumbent. Secondly, managers have some influence over the
appointment of a new auditor or the re-appointment of the incumbent auditor.
Managers set meeting agendas when auditor appointments are proposed, and they

typically have the proxy votes of a large number of shareholders. Thus, managers have
considerable influence over auditor hiring and firing.
If managers dislike qualified reports and have some influence over auditor
appointment, they may try to use auditor switching to avoid receiving qualified
reports. Teoh (1992) usefully identifies two ways in which this could occur. First, a
manager may actively use the auditor switch decision to avoid receiving a qualified
report. If a new auditor is less likely to give a qualified report compared to the
incumbent auditor, the manager may choose to switch. Similarly, if a new auditor is
more likely to give a qualified report compared to the incumbent, the manager may
choose not to switch. Second, if auditors earn client-specific rents, a manager may
obtain a more favourable report from an incumbent auditor by threatening to switch to
a new auditor. However, post-Enron, HIH and the CLERP Act 2004, the top 300 listed
companies are required to have an audit committee, which limits the ability for
managers to exercise such influence.
Geiger and Raghunandan (2002) find that auditors are more likely to issue an
unqualified audit opinion prior to a client filing for bankruptcy in the early years of the
auditor-client relationship. Myers et al. (2003) on the other hand find that as auditor
tenure increases, auditors place greater constraints on the degree of discretionary and
current accruals allowed by management. These results suggest that mandatory audit
firm rotation may have adverse effects on audit quality, as audit quality is lower in the
earlier years of the auditor-client relationship.
A number of other reasons have been proffered as to why clients decide to change
auditors. Chow and Rice (1982) find that the incidence of a qualified report was a
significant reason for clients to switch auditors. Schwartz and Menon (1985) find that
failing clients had a greater propensity to switch auditors, while Williams (1988) argues
that financially distressed clients have greater incentives to change auditors than healthy
clients in order for managers to portray a good image of the company. Hence, there is some
evidence that a large proportion of switching clients may be financially distressed.
However, a change in auditor is not always initiated by the client, but rather may be
initiated by the audit firm. Prior research indicates that audit firms by virtue of their own
internal quality procedures have a tendency to shed risky clients. An audit firm with a
risky client may decide to drop the client from its portfolio in order to reduce their
engagement risk ( Johnstone and Bedard, 2004). Auditors generally resign from clients
with high-financial distress and in receipt of a modified (particularly going-concern)
opinion (Krishnan and Krishnan, 1997). Shu (2000) also finds that an auditor resignation
is positively related to client legal exposure. The preceding arguments suggest that as a
result of risky clients deciding to change auditors, or auditors deciding to resign from
risky clients, a large proportion of clients that do switch will be financially unsound.
A large body of research underscores the higher levels of audit quality that the
top-tier audit firms can provide to their clients. DeAngelo (1981) argues that audit firms
with more clients have greater incentives to supply higher quality audits. Teoh and
Wong (1993) find that clients of Big N audit firms generally have higher earnings
response coefficients to audited earnings announcements, while Francis et al. (1999)
find that Big N audit firms were able to reduce the level of DA reported by their clients,
indicating a more effective assertion of independence. The prior literature suggests
that firms with higher levels of DA are able to manage earnings which lead to lower
audit quality.

Audit firm
rotation and
audit quality
423

MAJ
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424

Some audit firms differentiate themselves from their competitors by specialising in

auditing clients in particular industries. Craswell et al. (1995) find that
industry-specialists command a fee premium of around 16 per cent over non-industry
specialists, indicating that clients are willing to pay more for the services of such an
auditor. Schauer (2002) finds that clients of industry specialists had lower bid-ask
spreads, signifying lower levels of information asymmetry associated, and Krishnan
(2003) observes that clients of industry-specialists reported lower levels of accruals.
From the prior research, it appears that audit quality as measured by the propensity
to issue a going-concern opinion (GCO) and the level of DA is impacted by a change in
auditor. Therefore, we propose the following hypothesis, stated in the null:
H0. Audit firm rotation does not affect audit quality.
Sample selection and research design
Sample selection
This study examines auditor switches occurring between 1995 and 2003 for Australian
listed entities. It was decided to study the period from 1995, as data were readily
available for the year, and follows many of the Big N audit firm mergers. The period
1995-1999 also offers a comparable time period with 2000-2003. The period from 2000
has been marked by a number of considerable changes and events. The Ramsay
Report, issued in 2001, highlighted a number of threats to auditor independence,
including the provision of non-audit services along with recommendations for audit
partner rotation, which is included in CLERP 9. In addition, international high-profile
corporate collapses, including Enron, WorldCom, and HIH, brought auditor-client
relationships under even greater examination.
The initial sample consisted of 772 auditor switches for listed ASX entities between
1995 and 2003. Financial sector firms were excluded due to the inherent differences in
their reporting nature. After excluding clients where DA data were not available, those
with insufficient data, those reporting in a foreign currency, and for clients where a
matched entity could not be found, a total of 205 auditor switches resulted. The total
sample was used to measure changes in the level of DA with auditor tenure. Both
switching client firm-year observations and non-switching client firm-year
observations were included, yielding a total of 1,750 firm-year observations.
Each listed entitys independent auditor was identified from Craswells Who Audits
Australia database from 1994 to 2003. The age of clients was obtained from the ASX
web site and Aspect Huntleys DatAnalysis. Financial statement balances were also
obtained from Aspect Huntleys DatAnalysis. Takeover announcements were collected
from Connect 4, while debt and equity issues data were collected from Thompsons
SDC Platinum New Issues Database. Market capitalisation data were collected from
CRIF. Any missing data were hand collected from relevant sources. Variables were
winsorised at the fifth and 95th percentiles to remove the effect of significant outliers.
Research design
Audit quality has been defined in numerous ways, ranging from the relative degree to
which the audit conforms to applicable auditing standards (Krishnan and Schauer,
2001; Tie, 1999; McConnell and Banks, 1998; Cook, 1987), the market-assessed
probability that the financial statements contain material errors and that the auditor
will discover and report them (DeAngelo, 1981), the accuracy of the information

reported on by auditors (Titman and Trueman, 1986; Beatty, 1989; Krinsky and
Rotenberg, 1989), and a measure of the audits ability to reduce noise and bias and
improve fineness in accounting data (Wallace, 1980). Any metric used to measure audit
quality, however, are not perfect. Proxies for audit quality can only be devised in most
cases using publicly available information, and not private information known to the
auditor. The true audit quality is when the audit does not result in a Type I or II error
a failing company being given an unqualified report or a non-failing company being
given a qualified report.
In order to test our hypothesis that a change in audit firm has no effect on audit
quality, we estimate the following model:
AQ a b1 TENURE b2 FRISK b3 SIZE b4 LEV b5 CLEV
b6 RETURN b7 LDISTRESS b8 INVEST b9 FEERATIO
b10 SCFO b11 PRIOR b12 BIG_N b13 LEADER

b14 INDUSTRY 1
where AQ is audit quality, TENURE is the number of continuous years the incumbent
auditor has been with the client; FRISK is the client financial risk as measured by the
Zmijewski (1984) financial distress score[1]; SIZE is measured as the natural log of total
assets, LEV is the ratio of liabilities to assets, CLEV is the percentage change in LEV
during the year, RETURN is the percentage change in the book value of net assets over
the year, LDISTRESS is a dummy variable indicating if the client was financially
distressed[2] in the previous year, INVEST is investment securities measured by
current assets less-current debtors and inventory scaled by total assets, FEERATIO is
fee dependence as measured by non-audit fees divided by non-audit and audit fees paid
to the incumbent auditor, strong cash flows from operations (SCFO) is the net cash
flows from operations scaled by lagged total assets, PRIOR is a dummy variable
indicating if the client received a going-concern opinion in the prior year, BIG_N is a
dummy variable indicating if the firm was audited by a Big N auditor, LEADER is a
dummy variable indicating if the audit firm is a leader in the firms industry, and
INDUSTRY is a dummy variable indicating if a firm is in the mining sector.
Two measures of audit quality are employed within this study. First, audit quality
is measured as the propensity of the auditor to issue a GCO after controlling for other
factors that might affect this decision. A finding that auditors have a lower (higher)
propensity to issue going-concern opinions with increased tenure would provide
convincing evidence in favour of (in opposition to) mandatory rotation, i.e. if there is
lower propensity to issue GCO with increased tenure, then independence becomes
impaired. As the dependent variable in this measurement of audit quality is a
dichotomous variable, being the propensity to issue a going-concern opinion, a logistic
regression is run.
Second, the level of DA is used. DA are accruals that do not relate to normal
operating activities, and so a higher level of these accruals may indicate that
management has been able to exert its power over the auditor by being able to report
on terms favourable to management. As this second measurement of audit quality is a
continuous variable, an OLS regression is sufficient.
To measure DA, a performance-matched modified-Jones (1991) DA model was used.
Dechow et al. (1995) find that the modified Jones model had the highest statistical

Audit firm
rotation and
audit quality
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MAJ
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power in detecting earnings management, while Kothari et al. (2005) suggest matching
for performance helps to control for changes in accruals models associated with client
performance levels. Performance matched firms are matched by year and industry. DA
are estimated by:
TACC a1 a2 DSales 2 DRec a3 PPE a4 LTACC a5 Growth 1

426

where TACC is total accruals (operating net profit after tax cash flows from
operations), DSales is the change in sales for the year scaled by lagged total assets,
DRec is the change in accounts receivable during the year scaled by lagged total assets,
PPE is the gross property, plant and equipment scaled by lagged total assets, Growth
is the ratio of next years sales to this years, and the residual from the regression, 1, is
the measure of DA. The higher the level of the residual indicates a lower level of
accrual quality.
The model employed in this study is based closely on that used by DeFond et al.
(2002) and Carey and Simnett (2006). The Zmijewski (1984) probability of bankruptcy
score (FRISK) is included because clients closer to bankruptcy should have a higher
chance of receiving a going-concern report. SIZE is included because larger clients will
have more assets to sell in the event of financial difficulty, and should be less prone to
receiving a going-concern report. LEV and CLEV are employed because higher levels
of debt relative to total assets indicate higher risk, and greater changes in leverage may
suggest that the client is close to violating a debt covenant. RETURN is included,
because clients with higher levels of growth should be less likely to fail.
Results
Descriptive statistics
Descriptive statistics are presented in Table I. Panel A provides the results for the full
sample, with Panels B and C providing the results for the switching and non-switching
firms, respectively. Means of the variables are consistent with prior research. Of the total
sample, 4.06 per cent of firm-year observations result in a GCO being issued, which
increases to 5.37 per cent for switching firms (3.88 per cent for non-switching firms).
Table II outlines the correlation coefficients between the variables, using both
Pearson and Spearman rank correlations. Firms that were financially distressed in the
prior year have a high-negative correlation with both RETURN and SCFO.
Going-concern opinion
Table III presents the results of the logistic regression using the propensity to issue a
going-concern audit opinion as a proxy for audit quality. Panel A provides the results
for the full sample, with Panels B and C providing the results for the switching and
non-switching firms, respectively.
Results from Table III indicate that audit-client tenure increases the likelihood of the
auditor issuing a going-concern audit opinion. This result is inconsistent with the
results of Geiger and Raghunandan (2002) who found no statistically significant
relationship, and with those of Choi and Doogar (2005) who found a significantly
negative relationship between audit quality and tenure.
As expected, FRISK was positively associated with the propensity to issue a
going-concern opinion, indicating that firms with higher probabilities of bankruptcy
are more likely to receive a going-concern opinion. SIZE was found to have a

Mean

Std

Panel A: full-sample descriptive statistics (n 1,750)

GCO
0.0406
0.1974
DA
2 0.0239
0.1396
TENURE
7.2954
5.4532
FRISK
2 2.3819
1.6920
SIZE
17.9659
1.8758
LEV
5.8128
15.0874
CLEV
0.3075
0.8741
RETURN
0.1170
0.4600
LDISTRESS
0.5754
0.4944
INVEST
0.1389
0.1748
FEERATIO
0.3238
0.2389
SCFO
0.0376
0.2022
PRIOR
0.0063
0.0791
BIG_N
0.6983
0.4591
LEADER
0.1977
0.3984
INDUSTRY
0.5394
0.4986
Panel B: switching clients descriptive statistics (n 205)
GCO
0.0537
0.2259
DA
2 0.0168
0.1549
TENURE
2.1951
3.1593
FRISK
2 2.2218
1.7884
SIZE
17.6379
1.9665
LEV
10.2942
19.0199
CLEV
0.3610
0.9785
RETURN
0.1534
0.5569
LDISTRESS
0.6439
0.4800
INVEST
0.1542
0.1871
FEERATIO
0.2819
0.2548
SCFO
2 0.0123
0.2277
PRIOR
0.0537
0.2259

Variable
0.0000
20.0758
3.0000
23.3102
16.6620
0.0086
20.1122
20.0869
0.0000
0.0311
0.1316
20.0246
0.0000
0.0000
0.0000
0.0000
0.0000
20.0710
1.0000
23.4345
16.3290
0.0211
20.1527
20.1617
0.0000
0.0371
0.0228
20.0815
0.0000

0.0000
2 0.9269
1.0000
2 5.4695
11.4616
0.0000
2 0.6120
2 0.6797
0.0000
0.0002
0.0000
2 0.9795
0.0000

Quartile1

0.0000
2 1.0476
1.0000
2 8.1190
11.4616
0.0000
2 0.6120
2 0.6797
0.0000
2 0.5415
0.0000
2 0.9795
0.0000
0.0000
0.0000
0.0000

Min

0.0000
20.0069
1.0000
22.5547
17.4886
0.8149
0.0789
0.0555
1.0000
0.0848
0.2365
0.0406
0.0000

0.0000
20.0168
6.0000
22.4805
17.7435
0.1596
0.0553
0.0559
1.0000
0.0713
0.3078
0.0647
0.0000
1.0000
0.0000
1.0000

Median

0.0000
0.0427
1.0000
2 1.4187
18.8584
7.7183
0.4448
0.3164
1.0000
0.1964
0.4762
0.1154
0.0000

0.0000
0.0342
10.0000
2 1.6405
19.1076
1.9684
0.3602
0.2149
1.0000
0.1740
0.4902
0.1260
0.0000
1.0000
0.0000
1.0000

Quartile3

1.0000
0.6390
18.0000
4.1262
24.4907
63.0075
3.5736
1.5453
1.0000
1.0000
0.9077
0.6041
1.0000
(continued)

1.0000
0.8606
32.0000
4.1519
24.4907
63.0075
3.5736
1.5453
1.0000
1.0000
0.9779
0.6041
1.0000
1.0000
1.0000
1.0000

Max

Audit firm
rotation and
audit quality
427

Table I.
Sample descriptive
statistics

Table I.
Std

Min
1.0000
0.0000
0.0000
0.0000
20.0175
7.0000
22.4742
17.7731
0.1427
0.0521
0.0560
1.0000
0.0698
0.3140
0.0681
0.0000
1.0000
0.0000
1.0000

0.0000
2 0.0767
4.0000
2 3.3043
16.7108
0.0074
2 0.1088
2 0.0774
0.0000
0.0309
0.1440
2 0.0163
0.0000
0.0000
0.0000
0.0000

Median

0.0000
0.0000
0.0000

Quartile1

0.0000
0.0332
11.0000
21.6757
19.1437
1.5702
0.3528
0.2087
1.0000
0.1722
0.4940
0.1274
0.0000
1.0000
0.0000
1.0000

1.0000
0.0000
1.0000

Quartile3

1.0000
0.8606
32.0000
4.1519
23.5549
63.0075
3.5736
1.5453
1.0000
0.9721
0.9779
0.6041
0.0000
1.0000
1.0000
1.0000

1.0000
1.0000
1.0000

Max

Notes: GCO is a dummy variable indicating if a firm received a going-concern opinion; DA is a measure of the level of discretionary accruals; TENURE is
the number of continuous years the incumbent auditor has been with the client; FRISK is the client financial risk as measured by the Zmijewski (1984)
financial distress score; SIZE is measured as the natural log of total assets; LEV is the ratio of liabilities to assets; CLEV is the percentage change in LEV
during the year; RETURN is the percentage change in the book value of net assets over the year; LDISTRESS is a dummy variable indicating if the client
was financially distressed in the previous year; INVEST is investment securities measured by current assets less-current debtors and inventory scaled by
total assets; FEERATIO is fee dependence as measured by non-audit fees divided by non-audit and audit fees paid to the incumbent auditor; SCFO is the
net cash flows from operations scaled by lagged total assets; PRIOR is a dummy variable indicating if the client received a going-concern opinion in the
prior year; BIG_N is a dummy variable indicating if the firm was audited by a Big N auditor; LEADER is a dummy variable indicating if the audit firm is
a leader in the firms industry; and INDUSTRY is a dummy variable for firms in the mining sector

BIG_N
0.6195
0.4867
0.0000
LEADER
0.1951
0.3973
0.0000
INDUSTRY
0.4634
0.4999
0.0000
Panel C: matched non-switching clients descriptive statistics (n 1545)
GCO
0.0388
0.1933
0.0000
DA
20.0249
0.1375
21.0476
TENURE
7.9722
5.3343
1.0000
FRISK
22.4031
1.6783
28.1190
SIZE
18.0094
1.8598
11.9939
LEV
5.2182
14.3888
0.0000
CLEV
0.3004
0.8594
20.6120
RETURN
0.1121
0.4455
20.6797
LDISTRESS
0.5663
0.4957
0.0000
INVEST
0.1369
0.1731
20.5415
FEERATIO
0.3294
0.2363
0.0000
SCFO
0.0443
0.1977
20.9795
PRIOR
0.0000
0.0000
0.0000
BIG_N
0.7087
0.4545
0.0000
LEADER
0.1981
0.3987
0.0000
INDUSTRY
0.5495
0.4977
0.0000

Mean

428

Variable

MAJ
23,5

0.0627
(0.0087)
2 0.0121
(0.6145)
2 0.2112
(, 0.0001)
0.1552
(, 0.0001)
0.1157
(, 0.0001)
2 0.0124
(0.6028)
2 0.1151
(, 0.0001)
0.1298
(, 0.0001)
2 0.0134
(0.5762)
2 0.0522
(0.0291)
2 0.2252
(, 0.0001)
0.0911
(0.0001)
0.1976
(, 0.0001)
0.0232
(0.3323)
2 0.1671
(, 0.0001)
2 0.0949
(, 0.0001)
0.0071
(0.7652)
2 0.0801
(0.0008)
2 0.0778
(0.0011)
0.0506
(0.0344)
0.1082
(, 0.0001)
2 0.1159
(, 0.0001)
0.1146
(, 0.0001)
2 0.4679
(, 0.0001)
0.0357
(0.1349)
0.1639
(, 0.0001)
2 0.2768
(, 0.0001)
2 0.2634
(, 0.0001)
0.2686
(, 0.0001)
0.3684
(, 0.0001)
2 0.0511
(0.0325)

2 0.2043
(, 0.0001)
0.0365
(0.1267)
0.2193
(, 0.0001)

2 0.0156
(0.5147)
2 0.0068
(0.7763)

0.0537
(0.0245)

2 0.0194
(0.4180)
0.0201
(0.4015)
0.0369
(0.1229)
2 0.0005
(0.9822)
0.0331
(0.1665)
0.0366
(0.1255)
0.0342
(0.1529)
2 0.1622
(, 0.0001)
0.0191
(0.4251)
2 0.5004
(, 0.0001)
0.0513
(0.0320)

SIZE

Tenure

DA

0.0184
(0.4415)
0.0987
(, 0.0001)
2 0.2973
(, 0.0001)
0.1173
(, 0.0001)
2 0.1938
(, 0.0001)
0.0020
(0.9329)
2 0.1216
(, 0.0001)
0.0528
(0.0270)

0.2327
(, 0.0001)
0.0227
(0.3435)
2 0.0247
(0.3026)
0.0022
(0.9260)

FRISK

2 0.0225
(0.3467)
2 0.0950
(, 0.0001)
2 0.0146
(0.5410)
0.1393
(, 0.0001)
2 0.0924
(0.0001)
2 0.1744
(, 0.0001)
0.0187
(0.4339)

0.1130
(, 0.0001)
2 0.0154
(0.5193)
2 0.1415
(, 0.0001)
2 0.3326
(, 0.0001)
0.1094
(, 0.0001)

LEV

0.1467
(, 0.0001)
0.0040
(0.8665)
2 0.0310
(0.1949)
0.0597
(0.0125)
0.0329
(0.1689)
2 0.0238
(0.3191)

0.0320
(0.1806)
0.0576
(0.0160)
2 0.0751
(0.0017)
2 0.0713
(0.0028)
0.0295
(0.2172)
0.0028
(0.9085)

CLEV

2 0.2910
(, 0.0001)
0.0219
(0.3608)
0.0655
(0.0061)
0.2997
(, 0.0001)
0.0238
(0.3189)

2 0.1016
(, 0.0001)
2 0.0105
(0.6612)
2 0.0167
(0.4839)
0.0933
(, 0.0001)
2 0.3190
(, 0.0001)
2 0.0694
(0.0037)
0.2598
(, 0.0001)

RETURN

0.1109
(, 0.0001)
2 0.0979
(, 0.0001)
2 0.3901
(, 0.0001)
0.0248
(0.2991)

0.1298
(, 0.0001)
0.0553
(0.0207)
2 0.0869
(0.0003)
2 0.2714
(, 0.0001)
0.1584
(, 0.0001)
0.0409
(0.0874)
0.1015
(, 0.0001)
2 0.1847
(, 0.0001)

LDISTRESS

0.0299
(0.2112)
2 0.0473
(0.0479)
2 0.0013
(0.9557)

0.0062
(0.7947)
2 0.1240
(, 0.0001)
2 0.0962
(, 0.0001)
2 0.3188
(, 0.0001)
2 0.1993
(, 0.0001)
0.1075
(, 0.0001)
0.0417
(0.0814)
0.0595
(0.0127)
0.1426
(, 0.0001)

INVEST

0.0861
(0.0003)
2 0.0362
(0.1301)

2 0.0485
(0.0426)
0.0303
(0.2052)
0.0405
(0.0905)
0.2694
(, 0.0001)
2 0.0283
(0.2360)
2 0.0977
(, 0.0001)
0.0162
(0.4996)
0.0805
(0.0007)
2 0.0974
(, 0.0001)
0.0307
(0.1992)

FEERATIO
0.0911
(0.0001)
0.0501
(0.0360)
2 0.0880
(0.0002)
2 0.0507
(0.0338)
0.0808
(0.0007)
0.0310
(0.1950)
0.0177
(0.4583)
0.0474
(0.0475)
0.0248
(0.2991)
2 0.0149
(0.5322)
2 0.0328
(0.1707)
2 0.0558
(0.0195)

2 0.1984
(, 0.0001)
2 0.5203
(, 0.0001)
0.0998
(, 0.0001)
0.3476
(, 0.0001)
2 0.1827
(, 0.0001)
2 0.1722
(, 0.0001)
2 0.1065
(, 0.0001)
0.0920
(0.0001)
2 0.3505
(, 0.0001)
2 0.1734
(, 0.0001)
0.0496
(0.0381)

2 0.0601
(0.0120)

PRIOR

SCFO

Notes: Pearson (Spearman rank) correlation above (below) the diagonal; the two-tailed p-value is provided in parentheses with the correlation. GCO is a dummy variable indicating if a
firm received a going-concern opinion; DA is a measure of the level of discretionary accruals; TENURE is the number of continuous years the incumbent auditor has been with the client;
FRISK is the client financial risk as measured by the Zmijewski (1984) financial distress score; SIZE is measured as the natural log of total assets; LEV is the ratio of liabilities to assets;
CLEV is the percentage change in LEV during the year; RETURN is the percentage change in the book value of net assets over the year; LDISTRESS is a dummy variable indicating if the
client was financially distressed in the previous year; INVEST is investment securities measured by current assets less-current debtors and inventory scaled by total assets; FEERATIO is
fee dependence as measured by non-audit fees divided by non-audit and audit fees paid to the incumbent auditor; SCFO is the net cash flows from operations scaled by lagged total assets;
and PRIOR is a dummy variable indicating if the client received a going-concern opinion in the prior year

PRIOR

SCFO

FEERATIO

INVEST

LDISTRESS

RETURN

CLEV

LEV

FRISK

SIZE

TENURE

DA

GCO

GCO

Audit firm
rotation and
audit quality
429

Table II.
Pearson and Spearman
correlations

MAJ
23,5

430

Table III.
Logistic regression
going-concern opinion

Coefficient
estimate

Std error

Wald x 2

Panel A: full-sample (n 1750)

Intercept
4.3094 * *
TENURE
0.0570 * *
FRISK
0.3071 * * *
SIZE
2 0.4710 * * *
LEV
0.0038
CLEV
2 0.0189
RETURN
2 0.1800
LDISTRESS
0.6623 *
INVEST
2 1.2595
FEERATIO
0.8203
SCFO
2 1.2163 *
PRIOR
1.8439 * *
BIG_N
2 0.6020 * *
LEADER
2 0.1912
INDUSTRY
0.6559 * *
Log likelihood

2.0190
0.0267
0.0692
0.1163
0.0068
0.1391
0.2737
0.4024
0.8223
0.5938
0.6272
0.7959
0.2984
0.4567
0.3007
594.416

4.56
4.55
19.67
16.41
0.31
0.02
0.43
2.71
2.35
1.91
3.76
5.37
4.07
0.18
4.76

Panel B: switching clients (n 205)

Intercept
10.7286
TENURE
2 0.1666
FRISK
0.4614 * *
SIZE
2 0.7299 *
LEV
2 0.0205
CLEV
0.1401
RETURN
2 0.8198
LDISTRESS
0.1693
INVEST
1.0830
FEERATIO
2 3.2259
SCFO
3.2308
PRIOR
2.1499 * *
BIG_N
2 1.6093
LEADER
2 9.4295
INDUSTRY
0.6150
Log likelihood

7.7614
0.4192
0.2031
0.4305
0.0200
0.3529
0.7122
1.3866
2.1641
2.2570
2.7457
1.0357
1.0410
293.4000
0.8476
85.751

1.91
0.16
5.16
2.87
1.05
0.16
1.33
0.01
0.25
2.04
1.38
4.31
2.39
0.00
0.53

Variable

Panel C: matched non-switching clients (n 1,545)

Intercept
3.8100 *
TENURE
0.0570 *
FRISK
0.2864 * * *
SIZE
2 0.4556 * * *
LEV
0.0099
CLEV
2 0.1288
RETURN
2 0.1550
LDISTRESS
0.7063 *
INVEST
2 1.7941 *
FEERATIO
1.353 * *
SCFO
2 1.9129 * * *
BIG_N
2 0.6204 *
LEADER
2 0.1675

2.1499
0.0295
0.0782
0.1247
0.00741
0.1627
0.3196
0.428
0.9389
0.6602
0.7395
0.3303
0.4693

3.14
3.74
13.42
13.34
1.78
0.63
0.24
2.72
3.65
4.20
6.69
3.53
0.13
(continued)

Variable
INDUSTRY

Coefficient
estimate

Std error

0.7044 * *
Log likelihood

0.3304
507.451

Wald x

4.55

Notes: GCO a b1TENURE b2FRISK b3SIZE b4LEV b5CLEV b6RETURN

b7LDISTRESS b8INVEST b9FEERATIO b10SCFO b11PRIOR b12BIG_N
b13LEADER b14INDUSTRY *, * *, * * * significant at the 10, 5 and 1 per cent levels, respectively.
GCO is a dummy variable indicating if the firm received a going-concern opinion; TENURE is the
number of continuous years the incumbent auditor has been with the client; FRISK is the client
financial risk as measured by the Zmijewski (1984) financial distress score; SIZE is measured as the
natural log of total assets; LEV is the ratio of liabilities to assets; CLEV is the percentage change in
LEV during the year; RETURN is the percentage change in the book value of net assets over the year;
LDISTRESS is a dummy variable indicating if the client was financially distressed in the previous
year; INVEST is investment securities measured by current assets less-current debtors and inventory
scaled by total assets; FEERATIO is fee dependence as measured by non-audit fees divided by
non-audit and audit fees paid to the incumbent auditor; SCFO is the net cash flows from operations
scaled by lagged total assets; PRIOR is a dummy variable indicating if the client received a
going-concern opinion in the prior year; BIG_N is a dummy variable indicating if the firm was audited
by a Big N auditor; LEADER is a dummy variable indicating if the audit firm is a leader in the firms
industry; and INDUSTRY is a dummy variable for firms in the mining sector

significant negative coefficient, consistent with the expectation that larger firms will
have more opportunities to get out of financial difficulties, and thus be less likely to
receive a going-concern opinion. LDISTRESS and PRIOR both have positively
significant coefficients as per expectations, consistent with prior findings (DeFond
et al., 2002; Choi and Doogar, 2005). Additionally, firms in the mining sector are also
found to have a higher propensity to receive a going-concern opinion, consistent with
many firms in this sector being speculative or loss making firms.
Firms with larger investments (INVEST) and SCFO are less likely to receive a
going-concern opinion, as per expectations, as indicated with statistically significant
negative coefficients. Firms audited by an industry leader are found to have a lower
propensity to receive a going-concern audit opinion, however, the coefficient estimates
are not significant at any meaningful level.
Discretionary accruals
Table IV presents the results of the model using DA as the proxy of audit quality.
Again, Panel A provides the results for the full sample, with Panels B and C providing
the results for the switching and non-switching firms, respectively.
The main variable of interest in this study, TENURE, is both economically small
and statistically insignificant. This suggests that there is no significant change in audit
quality over time, leading to our conclusion that there may be no need to rotate
auditors. Results show that larger clients have higher levels of performance-matched
DA. Consistent with Johnson et al. (2002) and Ferguson et al. (2004), leverage is
positively related to the level of DA. There was a significant negative coefficient for
cash flow from operations and for firms operating in the mining sector. Companies that
experience higher growth in net assets were found to report lower levels of DA,
although statistically insignificant. This may be similar to industry growth, although

Audit firm
rotation and
audit quality
431

Table III.

MAJ
23,5

432

Table IV.
OLS regression DA

Variable

Coefficient
estimate

Std error

t-Stat

Panel A: full-sample (n 1750)

Intercept
20.2259 * * *
TENURE
0.0000
FRISK
20.0114 * * *
SIZE
0.0134 * * *
LEV
20.0004 *
CLEV
0.0038
RETURN
20.0070
LDISTRESS
20.0238 * * *
INVEST
20.1559 * * *
FEERATIO
0.0075
SCFO
20.4625 * * *
PRIOR
0.0572 *
BIG_N
20.0117 *
LEADER
0.0053
INDUSTRY
20.0131 * *
Adjusted R 2

0.0334
0.0005
0.0018
0.0018
0.0002
0.0032
0.0065
0.0059
0.0167
0.0116
0.0149
0.0337
0.0065
0.0070
0.0054
0.3796

2 6.77
2 0.05
2 6.52
7.36
2 1.88
1.20
2 1.08
2 4.02
2 9.32
0.64
2 31.15
1.70
2 1.81
0.75
2 2.41

Panel B: switching clients (n 205)

Intercept
20.3674 * * *
TENURE
0.0036
FRISK
20.0298 * * *
SIZE
0.0199 * * *
LEV
0.0003
CLEV
0.0140
RETURN
20.0167
LDISTRESS
20.0495 * * *
INVEST
20.1736 * * *
FEERATIO
20.0254
SCFO
20.4301 * * *
PRIOR
0.1063 * *
BIG_N
20.0289
LEADER
0.0079
INDUSTRY
20.0201
Adjusted R 2

0.1267
0.0030
0.0059
0.0069
0.0006
0.0096
0.0180
0.0211
0.0537
0.0371
0.0463
0.0409
0.0216
0.0247
0.0181
0.3472

2 2.90
1.21
2 5.05
2.90
0.56
1.46
2 0.93
2 2.35
2 3.23
2 0.68
2 9.28
2.60
2 1.34
0.32
2 1.11

Panel C: matched non-switching clients (n 1545)

Intercept
20.2102 * * *
TENURE
20.0003
FRISK
20.0093 * * *
SIZE
0.0129 * * *
LEV
20.0004 *
CLEV
0.0023
RETURN
20.0061
LDISTRESS
20.0203 * * *
INVEST
20.1535 * * *
FEERATIO
0.0099
SCFO
20.4711 * * *
BIG_N
20.0117 *
LEADER
0.0031

0.0342
0.0005
0.0018
0.0019
0.0002
0.0034
0.0069
0.0061
0.0175
0.0123
0.0157
0.0067
0.0073

2 6.14
2 0.65
2 5.11
6.86
2 1.82
0.67
2 0.87
2 3.33
2 8.77
0.80
2 30.02
2 1.74
0.43
(continued)

Variable
INDUSTRY
Adjusted R 2

Coefficient
estimate
20.0111 *

Std error

t-Stat

0.0057
0.3912

2 1.95

Notes: DA a b1 TENURE b2 FRISK b3 SIZE b 4 LEV b5 CLEV b6 RETURN

b7LDISTRESS b8INVEST b9FEERATIO b10SCFO b11PRIOR b12BIG_N
b13LEADER b14INDUSTRY *, * *, * * * significant at the 10, 5 and 1 per cent levels, respectively.
DA is a measure of discretionary accruals; TENURE is the number of continuous years the incumbent
auditor has been with the client; FRISK is the client financial risk as measured by the Zmijewski (1984)
financial distress score; SIZE is measured as the natural log of total assets; LEV is the ratio of
liabilities to assets; CLEV is the percentage change in LEV during the year; RETURN is the percentage
change in the book value of net assets over the year; LDISTRESS is a dummy variable indicating if the
client was financially distressed in the previous year; INVEST is investment securities measured by
current assets less-current debtors and inventory scaled by total assets; FEERATIO is fee dependence
as measured by non-audit fees divided by non-audit and audit fees paid to the incumbent auditor;
SCFO is the net cash flows from operations scaled by lagged total assets; PRIOR is a dummy variable
indicating if the client received a going-concern opinion in the prior year; BIG_N is a dummy variable
indicating if the firm was audited by a Big N auditor; LEADER is a dummy variable indicating if
the audit firm is a leader in the firms industry; and INDUSTRY is a dummy variable for firms in the
mining sector

Myers et al. (2003) and Blouin et al. (2005) did not find any significant relationship
between industry growth and DA. Firms audited by an industry leader are found to
have higher levels of DA but not at any meaningful level of significance.
Sensitivity analysis
The TENURE variable was replaced by two dummy variables indicating length of
tenure greater than five and six years. Untabulated results are consistent with the
earlier results, using both the propensity to issue a GCO and DA as proxies for audit
quality. The implication of these results suggest that contrary to an argument for
mandatory audit firm rotation, the length of audit tenure does not have an
economically or statistically significant effect on audit quality, as measured by the
level of DA, and the propensity to issue a going-concern audit opinion increases with
the length of audit firm tenure.
Carson et al. (2006) report that since 2001 there has been an increase in the percentage
of firms that receive a going-concern opinion. To test our results to the sensitivity of
changes in audit behaviour, we included a dummy variable for firm years from 2001 to
the end of our sample period. Including this variable does not alter our results.
Conclusions and limitations
Using two proxies for audit quality, being the propensity to issue a going-concern audit
opinion and the level of DA, we find that audit quality is not negatively affected by
audit firm tenure. Using the propensity to issue a going-concern opinion, the length of
audit tenure actually increases audit quality. However, when using the level of DA to
measure audit quality there is neither an increase nor a decrease in audit quality
conditional on the length of auditor tenure. Given this result, we conclude that there
are minimal, if any, benefits of imposing mandatory audit firm rotation onto

Audit firm
rotation and
audit quality
433

Table IV.

MAJ
23,5

434

Australian firms. Further, given the costs involved in switching auditor, it does not
appear that mandatory audit firm rotation would be beneficial to the market. In order
to address the concerns that have arisen recently around auditor independence and
audit quality, other initiatives are more likely to have a greater impact than imposing
mandatory audit firm rotation.
However, there are other potential benefits of mandatory audit firm rotation that we
do not consider in this context which may detract from the generalisation of our results.
As indicated prior, audit quality can be divided into perceived audit quality and actual
audit quality (Taylor, 2005). This study only examines levels of actual audit quality.
While we conclude that actual audit quality does not improve for firms that rotate
auditor, the perception of audit quality may indeed have increased. Further research is
required to investigate the perception of audit quality on mandatory audit firm rotation,
as well as total audit quality combining both actual and perceived quality.
The proxies used in this study to measure audit quality, however, are not perfect.
Proxies for audit quality can only be devised in most cases using publicly available
information, and not information known to the auditor. The first proxy used, that being
the propensity to issue a going-concern report, attempts to capture the level of
independence of an auditor. However, a weakness of this proxy is that the propensity
to issue a going-concern report is conditional on a firm being in need of such a report.
The second proxy for audit quality, that being the level of DA, attempts to capture
the amount of influence management has over the auditor in the sense that firms with
higher levels of DA are more likely to be able to push the boundaries of generally
accepted accounting principles by manipulating the accrual component of earnings. In
the current study, a performance-matched modified Jones (1991) model has been used
to measure DA, which itself has received criticism in the literature. However, this
model has been shown to outperform other attempts at estimating the level of
manipulation in financial reporting through accruals.
Additionally, the signal that an audit firm switch sends to the market may be of
interest to investors, and send a valuable signal which mandatory audit firm rotation
would remove. To fully understand the signal, information about the reasons for the
switch, and who instigated the switch, be it the client or the audit firm, would need to
be known. In the Australian environment, however, this information is not publicly
available. Alternatively, mandatory audit firm rotation may increase the perception of
audit quality, which in and of itself is an important component to the efficient
operations of financial markets.
Notes
1. Calculated as per Carcello et al. (1995): FRISK 2 4.803 2 3.6 (net profit/total assets) 5.4
(total liabilities/total assets) 2 0.1 (current assets/current liabilities).
2. The measure of financial distress employed is negative cash flows from operations and/or a
loss after abnormal items.
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Corresponding author
Andrew B. Jackson can be contacted at: a.b.jackson@unsw.edu.au

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