kwon et al - 2010 - mandatory audit firm rotation and audit quality - evidence from the korean audit market [mafr]

Mandatory Audit Firm Rotation and Audit Quality:
Evidence from the Korean Audit Market



Soo Young Kwon
Korea University


Young Deok Lim
University of New South Wales


Roger Simnett
University of New South Wales








November 2010


We are grateful for the insightful comments from Michael Ettredge and
participants at the seminars at the University of New South Wales.

Mandatory Audit Firm Rotation and Audit Quality:
Evidence from the Korean Audit Market

Abstract
Using a unique database consisting of 12,463 firm-year observations in Korea
between 2000 and 2007, this study examines the effect of mandatory audit firm
rotation on audit hours, audit fees, and audit quality. Since the Korean
government mandated audit firm rotation in 2006, (1) audit hours increased, (2)
audit fees increased, and (3) audit quality (measured as abnormal discretionary
accruals) remained unchanged or decreased slightly. These results, which are
robust to controlling for potential endogeneity between audit hours and earnings
management and to measuring audit quality alternatively, suggest that mandatory
audit firm rotation increases the cost for audit firms and clients while having no
discernable positive effect on audit quality.

Keywords: Mandatory Audit Firm Rotation, Audit Hours, Audit Fees, Audit
Quality
JEL Classifications: M42, M48

Data Availability: Most of the financial data used in the present study are
available from the KIS Value database. The data for audit hours and fees were
drawn from statements of operating results filed with the Financial Supervisory
Services (FSS) in Korea.

1
Mandatory Audit Firm Rotation and Audit Quality:
Empirical Evidence from the Korean Audit Market

1. Introduction

The Korean Financial Supervisory Services (FSS) has mandated audit firm
rotation in 2006. The mandatory audit firm rotation, which requires audit firms to be
rotated every seven years, is intended to reduce auditors’ incentives to develop long-
term relationships with their clients so that their preference for conservative
accounting choices may be induced. This study examines the effect of the mandatory
audit firm rotation in Korea on audit hours, audit fees, and discretionary accruals.
Further, the study explores a forced auditor change setting that allows for a more
direct examination of how audit quality is affected by a mandatory auditor change and
an increase in auditor skepticism.
Whether audit firm rotation should be made mandatory is an issue that has been
debated for almost five decades in the U.S. and around the world. Proponents of
mandatory audit firm rotation have argued that a new auditor would bring to bear
greater skepticism and a fresh perspective that may be lacking in long-standing
auditor-client relationships.
1
They have also claimed that when a company has been a
client of an audit firm for a number of years, the client can be viewed as a source of a
perpetual annuity, potentially impairing the auditor’s independence. Conversely,
opponents of mandatory firm rotation have argued that audit quality would suffer
under such a regime because the auditor would lack familiarity with the client and its
industry (AICPA [1992]). Furthermore, opponents have pointed to a higher incidence
of problem audits in the early years of the auditor-client relationship than in the later
years (St. Pierre and Anderson [1984]).
The Enron debacle in late 2001 (and its high-profile collapse) has refocused
attention on the profession’s effectiveness in protecting public interest. The Sarbanes-
Oxley Act [2002] required the General Accounting Office (GAO
2

) to conduct a study
of the potential effects of requiring the mandatory rotation of auditors registered
under the Act. The GAO’s study concluded that mandatory audit firm rotation might


1
Benson [2002] suggested that institutional investors have focused on this issue and opposed
shareholder approval of any audit firm that has been retained by a company for more than five years.
2
Effective July 7, 2004, the GAO changed its name to the Government Accountability Office.

2
not be the most efficient way to strengthen auditor independence. Consequently, the
legislatures settled on the rotation of lead partners. However, the GAO has left open
the possibility of revisiting the mandatory audit firm rotation requirement if the other
requirements of the Sarbanes-Oxley Act do not lead to improved audit quality. Thus,
despite concerns that mandatory rotation could diminish the quality of financial
reporting, the demand for mandatory audit firm rotation has remained.
Because the effects of mandatory firm rotation cannot be analyzed using archival
data, prior research has examined the relation between audit quality and audit firm
tenure. As proxies for audit quality, they employ discretionary accruals, the cost of
debt financing, earnings response coefficients (ERCs), going-concern reports, AAERs
(Accounting and Auditing Enforcement Releases), auditor litigation, and fraud.
Overall, previous studies have suggested that long auditor tenure is not associated
with a decline in audit quality but that short tenure is associated with lower quality
audits (Geiger and Raghunandan [2002], Johnson et. al. [2002], Carcello and Nagy
[2004], Myers et. al. [2003], Ghosh and Moon [2005]). However, no study has
directly examined the effect of mandatory audit firm rotation because all have
examined audit firm rotation in the context of a voluntary change regime. Thus, the
results of prior research may not extend to a mandatory change regime.

Because auditor change is widely known to be endogenously determined, the
association between auditor tenure and audit quality has the self-selection bias (i.e.,
clients with long tenure tend to be good performers with less incentives to manage
earnings). Furthermore, unlike those under a mandatory audit firm rotation regime,
companies under a voluntary change regime are not required to change auditors in
future, and thus, they may still retain bargaining power over successor auditors. To
date, few studies have examined the effect of audit firm rotation in the mandatory
regime context because of the lack of data from a mandatory audit firm rotation
environment.
However, Korea has mandated the audit firm rotation requirement since 2006.
This allows a direct examination of the impact of a forced auditor change on audit
quality under a mandatory audit firm rotation regime. Furthermore, by employing
publicly disclosed data on audit hours and fees to determine the effects of a forced
auditor change on audit hours (auditor effort/cost) and audit fees (cost to clients), this

3
study provides a better understanding of the costs and benefits of mandatory audit
firm rotation.
Using a unique database consisting of 12,463 firm-year observations in Korea
between 2000 and 2007, this study examines the effect of mandatory audit firm
rotation on audit hours, audit fees, and audit quality. Since the Korean government
mandated audit firm rotation in 2006, (1) audit hours increased, (2) audit fees
increased, and (3) audit quality (measured as abnormal discretionary accruals)
remained unchanged or decreased slightly. These results, which are robust to
controlling for potential endogeneity between audit hours and earnings management
and to measuring audit quality alternatively, suggest that mandatory audit firm
rotation increases the cost for audit firms and clients while having no discernable
positive effect on audit quality.
Our study contributes to the literature in several ways. This study explicitly
examines the impact of mandatory audit firm rotation on audit quality under a

mandatory audit firm rotation regime. Previous studies have examined either the
effects of auditor tenure on earnings quality or the characteristics of firms voluntarily
changing auditors on the engagement under a voluntary rotation system, not under a
mandatory system.
3
Thus, the results from a voluntary auditor change environment
may not extend to a mandatory auditor change environment if such a requirement is
imposed on public companies.
Second, to the authors’ knowledge, the present study is the first to employ the
rich dataset of audit hours and audit fees to address an important policy question
the effect of mandatory auditor change on auditor efforts (auditor cost), audit fees
(client cost), and discretionary accruals (audit quality) under one study. Prior
studies have employed audit tenure, the auditor’s opinion, or financial statement
restatements to explore the impact of mandatory audit firm rotation. However, they
have not examined the rotation-related costs to clients and audit firms. The present
study has useful implications for regulators, members of the accounting profession,
and financial statement users as they deliberate on the costs and benefits of mandatory
audit firm rotation.


3
One recent study by Ruiz-Barbadillo et al. [2009] examined the impact of mandatory audit firm
rotation on auditor behavior in the Spanish context. They used the likelihood of issuing going-concern
opinions as a proxy for audit quality and focused on financially distressed firms from 1991~2000.

4
Third, this study provides evidence for the incremental effect of mandatory
auditor changes over voluntary auditor changes on auditor efforts, audit fees, and
discretionary accruals. Further, this study explicitly considers auditors’ responses to
the rule by increasing audit hours; the auditors were expected to change their audit

hours in anticipation of government scrutiny.
The remainder of the paper proceeds as follows. Section 2 provides a review of
the controversy and literature about mandatory rotation. Section 3 develops the
hypotheses, and Section 4 presents the models and key variables. Section 5 describes
the sample and reports the results. Section 6 provides additional analyses, and Section
7 concludes with a summary.

2. Controversy over Mandatory Rotation and Literature Review

2.1 Debate on Mandatory Audit Firm Rotation
2.1.1 Controversy over Mandatory Audit Firm Rotation Among Politicians,
Regulators, and Accounting Practitioners
In their seminal work, Mautz and Sharaf [1961] suggested that extended auditor-
client relationships can have a detrimental effect on auditor independence because an
auditor’s objectivity about a client decreases over time. Further, the Metcalf
Committee indicated that mandatory audit firm rotation is a way to bolster auditor
independence (U.S. Senate [1976]). Regulators have suggested a link between auditor
tenure and reductions in earnings quality and recommended imposing such a
requirement (Commission on Auditors’ Responsibilities [1978]; Division for CPA
firms, [1992]).
The Enron scandal and the Andersen audit failure rekindled the issue of
mandatory audit firm rotation. Mandatory audit firm rotation was advocated in the
congressional testimony by Arthur Levitt, Jr., former chairman of the SEC; Lynn E.
Turner, former SEC chief accountant; and Charles A. Bowsher, a chair of the Public
Oversight Board. They suggested that serious consideration be given to requiring
companies to change their audit firm every 5~7 years to ensure that fresh and
skeptical eyes are always looking at the numbers. Several bills containing provisions
limiting auditor tenure and mandating auditor rotation were proposed in the House
and the Senate as part of an effort to improve financial reporting and protect investors.

5
However, the views expressed above have not been universally accepted. The
Cohen Commission in 1978 concluded that mandatory rotation costs would exceed
the benefits. The auditing profession has argued that mandatory audit firm rotation
would not only decrease audit quality but also increase the cost of an audit (AICPA
[1992]). The 1996 GAO study opposed auditor rotation citing its detrimental impact
on the value of continuity in conducting audits. The AICPA’s Quality Control Inquiry
Committee of the SEC Practice Section analyzed 406 cases of alleged audit failure
between 1979 and 1991 and concluded that allegations of audit failure occurred
almost three times as often when an audit firm was performing its first or second
audit of a given client (AICPA [1992]).
Given the conflicting views on auditor tenure, Congress decided in 2002 not to
require the mandatory rotation of audit firms. Instead, it directed the GAO to conduct
research on the potential effects of mandatory audit firm rotation on audit quality; the
GAO’s 2003 study concluded that mandatory audit firm rotation may not be the most
efficient way to strengthen auditor independence and improve audit quality. As a
result, Congress decided that it was necessary to require mandatory partner rotation
(not mandatory audit firm rotation) every five years to increase audit quality.
4

However, the GAO has left open the possibility of revisiting the mandatory audit
firm rotation requirement if the other requirements of the Sarbanes-Oxley Act do not
lead to improved audit quality (GAO [2003, 5]). In addition, several parties including
the GAO [2003, 9], the New York Stock Exchange [2003, 11], the Commission on
Public Trust and Private Enterprise [2003, 3], and TIAA-CREF [2004, 9] suggested
that periodically changing audit firms may enhance audit quality. Therefore, although
mandatory rotation is not required at the present time, regulators, policy makers, and
institutional investors have continued to be interested in this topic.

2.1.2 Pros and Cons of Mandatory Audit Firm Rotation

The most widely used arguments in favor of auditor rotation are as follows. First,
if auditors continue to audit the entity for too long, they risk developing too close a


4
Following the Sarbanes-Oxley Act, the SEC issued its rules on audit partner rotation in 2003; Rule 2-
01(c)(6) of Regulation S-X requires the mandatory rotation of the lead partner and the concurring
partner every five years in relation to their audit client.

6
relationship with the client and compromising independence.
5
Second, periodically
having a new auditor would bring a fresh look to the public company’s financial
reporting and help the auditor appropriately deal with financial reporting issues
because the auditor’s tenure would be limited under mandatory audit firm rotation.
Third, mandatory audit firm rotation would help in the more even development of the
auditing profession, helping smaller and medium-sized audit firms to grow.
There are several arguments against mandatory audit firm rotation. First, new
auditors may miss problems in the period under review because they lack adequate
experience with the client to notice either unusual events or important changes in the
client’s environment.
6
Second, there are not enough large audit firms to address the
audit requirements of large companies, making auditor rotation impracticable at the
ground level. Third, mandatory rotation increases audit start-up costs and the risk of
audit failure because the incoming auditor places increased reliance on the client’s
estimates and representations in the initial years of the engagement. Thus, there may
be negative effects on audit quality and effectiveness in the first years following a
change. Fourth, the rotation would only prevent auditors from building in-depth

institutional knowledge of a client and its business.
7

It appears that politicians, regulators, analysts, and small audit firms favor
mandatory audit firm rotation as a solution to the perceived lack of objectivity and
independence of auditors. On the other hand, academicians, companies, and large
audit firms tend to be against mandatory audit firm rotation because changing
auditors is costly. It is certainly interesting to observe such different perspectives on
the same issue.
Without empirical evidence, it is neither clear whether mandatory rotation would
really ensure audit quality by strengthening auditor independence nor obvious
whether the rotation rule would hamper audit quality because of insufficient
knowledge of clients.


5
For example, Waste Management, W. R. Grace, and JWP were identified as three cases in which, in
the context of a long-term audit relationship, an issue was identified by the auditors but then not
resolved (Turner [2001]).
6
The accounting profession has argued that uncertainty about the characteristics of the client increases
the potential for audit failures early in the auditor-client relationship (PricewaterhouseCoopers [2002]).
7
Most obviously, the cumulative knowledge of the existing audit team is lost, and the new auditor
faces a steep learning curve. The increasing complexity of large groups and the complexities
surrounding the financial reporting of their activities suggest that it can take the new auditor several
years to fully understand the business (CGAA).

7
The response to mandatory rotation varies from firm to firm. Intel’s audit

committee decided in 2003 to change its auditor regularly in the wake of calls by a
number of advocates for better corporate governance. Intel had been audited by Ernst
& Young since the chipmaker was founded in 1968. However, the audit committee
had decided that Intel might benefit from obtaining a fresh look at its financial
accounting and internal control processes. LESCO also reported in 2003 that its board
of directors appointed KPMG as the company’s independent auditor by replacing
Ernst & Young. LESCO disclosed in a filing with the SEC that there were no
disagreements between the company and Ernst & Young on any matter of accounting
principles or practices, financial statement disclosure, or auditing scope or procedure.
By contrast, DuPont periodically rotated its auditor not only to assure
disinterestedness on the part of the auditor but also to provide the company with a
fresh perspective (Zeff [2003]). However, in 1954, it allowed Price Waterhouse & Co
to remain as the permanent auditor, particularly in view of the increasing size and
complexity of the company and its extensive overseas operations. These two
seemingly conflicting views under the voluntary auditor change setting suggest that
no clear consensus has emerged in favor of or against the concept of auditor rotation.

2.1.3 Trends in Mandatory Audit Firm Rotation Worldwide
In the wake of a number of financial reporting failures (notably in the U.S. but
also in Europe), legislators and regulators have questioned the quality of auditors’
work. The countries that already have an audit rotation system in place are Italy,
Brazil, Malaysia, Singapore, and Korea. Italy has a statutory requirement for audit
firm rotation every nine years. In Brazil, companies have been made to change
auditing firms every three years. In Singapore, banks are required to change audit
firms every five years, but there is no requirement on listed companies. In 2003,
Korea adopted the mandatory rotation rule and required listed firms to rotate their
auditors every six years starting in 2006.
Spain introduced mandatory rotation in 1988 after a maximum period of nine
years but abolished the mandatory rotation requirement in 1995. In 1998, France
considered the reform proposal with a provision to limit the term of the statutory

auditor to six years but dropped the provision from the proposal at the final stage.

8
Similarly, Austria approved a law in 2002 that required audit firm rotation by the end
of six years, but the requirement has been put on hold.
The U.K. concluded that the mandatory rotation of firms was not necessary.
Instead, it decided to increase the frequency of rotation for the lead audit partner to
every five years. Hong Kong also adopted audit partner rotation in 2003 by requiring
lead audit partners to be rotated every five years. Federation des Experts Compatables
Europeans (FEE) recommended in its letter to the European Commission that the
proposed Directive be amended to omit the suggestion that the mandatory rotation of
audit firms should be seen as an alternative to the mandatory rotation of partners.
Accordingly, none of countries in Europe have introduced mandatory audit firm
rotation.

2.2 Literature Review of Mandatory Audit Firm Rotation
Some studies have reported results consistent with the perspective that audit
quality deteriorates as the length of audit tenure increases. Mautz and Sharaf [1961]
suggested that extended client-auditor relationships alone impede auditor
independence. Deis and Giroux [1992] reviewed audit quality letters produced by a
public audit agency and concluded that audit quality declines as audit tenure increases.
Davis et al. [2002] suggested that longer auditor tenure is associated with the use of
discretionary accruals to manage earnings. This argument is reinforced by Bazerman
et al. [2002], who provided evidence of stronger psychological bias with increasing
ties between the auditor and its client. Dopuch et al. [2001] concluded that mandatory
rotation can increase auditor independence because rotation requirements constrain
low-balling in anticipation of potential income from future engagements.
On the other hand, other studies have provided conflicting results. St. Pierre and
Anderson [1984] and Stice [1991] suggested that many audit errors and lawsuits
occur during early years of the client-auditor relationship. Geiger and Raghunandan

[2002] determined that auditors become more efficient at collecting and evaluating
audit evidence as tenure increase. Carcello and Nagy [2004] proposed that the
probability of fraudulent financial reporting is highest early in the audit firm’s tenure
and is not substantially higher for instances of longstanding audit engagements.
Myers et al. [2004] found no evidence of an association between the nature and
severity of the restatement and auditor tenure. Mansi et al. [2004] suggested that

9
longer audit firm tenure is associated with higher bond ratings and a lower cost of
debt. Ghosh and Moon [2005] found that earnings response coefficients increased
with the length of audit firm tenure, suggesting that earnings have a greater influence
on equity prices as auditor tenure increases. Davis et al. [2009] demonstrated that
both short- and long-term auditor engagements were associated with the increased use
of discretionary accruals to meet and beat earnings forecasts in the pre-SOX period
but that the results disappeared following SOX.
A study by the University of Bocconi in Italy, using the number of suspensions
of partners imposed by the Italian nation commission as a proxy for audit quality,
concluded that mandatory auditor rotation was detrimental to audit quality because it
increased start-up costs and caused disruptions in the appointment phase. Ruiz-
Barbadillo et al. [2009] examined the impact of mandatory audit firm rotation on
auditor behavior in the Spanish context and found no evidence that a mandatory
rotation requirement is associated with a higher likelihood of issuing going-concern
opinions.
Overall, prior research on the effect of audit firm tenure on audit quality has
been mixed, although recent studies have tended to support higher audit quality as
auditor tenure increases. However, regardless of whether the results have been in
favor of or against mandatory audit firm rotation, previous studies have not
determined whether mandatory audit firm rotation would improve or hamper audit
quality. They have merely provided evidence that under the system of voluntary audit
firm rotation, audit quality does not appear to decrease with tenure. Therefore, any

generalization of such findings to a regime with mandatory audit rotation should be
implemented with caution.
To better understand the impact of mandatory audit firm rotation, recent studies
have taken two important approaches. The first approach examines the effect of
mandatory audit firm rotation on audit quality under a real mandatory audit firm
rotation regime. Recent studies have taken this approach by investigating the case of
Arthur Andersen (AA), where ex-AA clients were forced to change auditors because
of AA’s failure (Nagy [2005], Blouin et al. [2007]). However, this setting is not a true
mandatory audit firm rotation regime because companies still possessed considerable
amounts of bargaining power in the case of the AA failure.

10
The second approach examines the effect of audit partner rotation on audit
quality (Carey and Simnett [2006], Chi et al. [2009], Chen et al. [2008]).
8
However,
audit partner rotation differs considerably from audit firm rotation; although the
former increases the risk of audit failures during a partner’s initial years on an
engagement and brings fresh eyes to an engagement, increasing audit quality, the
extent of the fresh view is less than that of the latter because of the potential
knowledge transfer and staff sharing within the audit firm. Thus, it is not clear
whether the results from these studies can be extended to a mandatory audit firm
rotation setting. Furthermore, Bamber and Bamber [2009] suggested that, compared
with audit firm rotation, audit partner rotation is likely to yield second-order effects.
Thus, audit partner rotation is not likely to have a substantial effect on audit quality.
Despite these attempts, previous studies have been limited by the fact that the
setting remains the voluntary rotation regime. In this regard, the present study
examines the effect of rotation at the time that mandatory rotation occurs, rather than
the effect of auditor tenure. In addition, the study employs audit hours and audit fees
to capture the rotation-related costs to audit firms and their clients; the study also uses

discretionary accruals to measure client managers’ accounting discretion.

3. Institutional Background and Hypotheses Development

3.1 Mandatory Audit Firm Rotation in Korea

The Korean government has initiated many legal and regulatory reforms since
the 1997 financial crisis. In particular, the government has launched bold programs to
improve corporate governance and accounting standards. In the wake of the Sarbanes-
Oxley Act of 2002, which the U.S. enacted in response to the accounting irregularities
of Enron, the Korean government formed a task force composed of experts from both
the public and private sectors, and the group was mandated to formulate robust


8
Carey and Simnett [2006] found that audit quality, proxied by the propensity to issue going-concern
opinions and the incidence of just beating (missing) earnings benchmarks, decreased under long
partner tenure. By using audit data from Taiwan, Chi, et al. [2009] found no support for the belief that
mandatory auditor audit partner rotation enhances audit quality, whereas Chen et al. [2008] found that
audit quality increased with partner tenure.

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reform proposals to further strengthen Korea’s corporate governance and accounting
standards.
In April 2003, Korean regulators proposed an accounting reform bill that would
require listed companies to change auditors periodically. The bill passed through the
National Assembly, marking an epoch in the Korean accounting market; this contrasts
the situation in the U.S., where the implementation of the same scheme failed in 2002.
The mandatory rotation rule, which requires auditor rotation after six consecutive
years of audit engagement, is intended to prevent auditors from compromising their

duty or independence because of financial interests or a long-term relationship with
the same client. The FSS alleged that companies can easily manipulate their financial
statements in connivance with their long-standing auditor because an accounting firm
conducts audits on a listed company for a number of years.
Korea’s adoption of mandatory audit firm rotation provides us with an ideal
setting in which its real impact on costs and audit quality can be examined. The
voluntary setting provides an understanding of one aspect of a mandatory rotation
regime, but it does not truly allow for the examination of the effect that a forced
auditor change has on the level of audit quality. The voluntary setting considers a
company’s choice of an audit firm as exogenous, but in reality, the company is free to
choose any firm it deems appropriate. Thus, this raises the issue of endogeneity
because typically, troubled firms change auditors more often than sound ones.
Furthermore, there seems to be incentives for managers to switch to incompetent
auditors the moment a problem occurs. In this study, the endogeneity issue does not
arise because we deal with the mandatory rotation regime. In addition, we exploit
publicly disclosed audit hours and audit fees data to complement discretionary
accruals.

3.2 The Effect of Mandatory Audit Firm Rotation on Audit Hours
During the first year of a new appointment, more man-hours are necessary,
together with the deployment of more qualified resources than those usually
employed during the auditing of financial statements. Prior studies (Deis and Giroux
[1996], Caramanis and Lennox [2008]) suggested that if a client changes its auditor,
the incoming auditor is more likely to work longer hours because its start-up costs

12
(e.g., assessing the strength of internal controls) are high. Based on this reasoning, we
propose the following hypothesis:

H1-1: An auditor is more likely to spend more audit hours in its initial

audit engagement than in its subsequent audit engagements.

The engagement by mandatory audit firm rotation is a type of initial audit
engagement. However, it differs from the initial engagement because regulators
scrutinize the results of audits from mandatory audit firm rotation. Thus, auditors
under the mandatory auditor regime are more likely to make more audit effort to meet
regulators’ expectations. Furthermore, voluntary auditor change can be motivated by
opinion shopping; thus, a company may end up with a lower quality audit firm. Thus,
an auditor has less incentive to make audit efforts than an auditor under the
mandatory audit firm rotation regime.
On the other hand, low-balling practices to obtain the initial engagement may
result in insufficient audit work being done as auditors try to meet lower budgets. The
2003 GAO study suggested that if intensive price competition occurs, the expected
benefits of mandatory audit firm rotation can be adversely affected if audit quality
suffers as a result of audit fees that do not support an appropriate level of audit work.
In this case, mandatory audit firm rotation is more likely to reduce audit efforts than
the initial audit engagement.
Based on these two conflicting perspectives, we propose the following
hypothesis in an alternate form:

H1-2: An auditor in its initial audit engagement is likely to spend more
audit hours under the mandatory audit firm rotation regime than that
under the voluntary auditor change regime.

3.3 The Effect of Mandatory Audit Firm Rotation on Audit Fees
3.3.1 Without the Inclusion of Audit Hours as Determinants of Audit Fees
Competition among public accounting firms for providing audit services should
affect audit fees to some extent. Firms may be using low bids to obtain their initial
audit engagement. DeAngelo [1981] suggested that the existence of a learning curve

13
in auditing can lead to low-balling (price below cost) when auditors bid to perform a
new engagement. Simon and Francis [1988] suggested that price cutting exists in
early periods and that fee discounting occurs when clients incur considerable
incremental costs when changing auditors. Deis and Giroux [1996] provided
empirical evidence that initial audits are associated with lower audit fees.
Based on these results, we propose the following hypothesis:

H2-1: An auditor is more likely to charge lower audit fees in its initial
audit engagement than in its subsequent audit engagement.

The rule of mandatory external rotation might intensify price competition. In the
case of auditing, which is generally considered as a public interest activity, such
competition may be considered as inappropriate. If this were the case, then audit fees
under the mandatory audit firm rotation regime would be less than those under the
voluntary auditor change regime.
On the other hand, Petty and Cuganesan [1996] argued that auditing fees are
likely to escalate because auditors may be unable to absorb the initial higher costs
associated with the first years of auditing. Engagements through mandatory audit firm
rotation differ from voluntary initial engagements because the former is a case in
which the economic benefits are truncated from an extended period of repeat
engagements. Thus, auditors have fewer incentives to low-ball audit fees in initial
engagements. Furthermore, clients have less bargaining power because of the lack of
auditor choice. Based on these two conflicting views, the following hypothesis is
proposed:

H2-2: Auditors under the mandatory audit firm rotation regime are likely
to charge higher audit fees than those in their initial audit
engagement under the voluntary auditor change regime.

3.3.2 With the Inclusion of Audit Hours As Determinants of Audit Fees
Audit fees are determined by both audit efforts (audit cost) and audit risk. As
discussed above, mandatory audit firm rotation is likely to affect auditors’ efforts
because of regulators’ scrutiny as well as high start-up costs associated with the initial

14
engagement. In this case, it is not clear whether an audit fee increase stems from
compensation for additional work or from mandatory audit firm rotation per se. To
disentangle the effect of mandatory audit firm rotation on audit fees from that of audit
efforts, we further control for auditors’ efforts.

3.4 The Effect of Mandatory Audit Firm Rotation on Earnings Quality
In the voluntary auditor change setting, audit quality is more likely to deteriorate
for two reasons. First, a client is likely to hire an auditor with audit quality not higher
than its outgoing auditor. In the case of resignation, a client has difficulty finding an
auditor that can provide a similar level of audit quality. In the case of dismissal, a
client has an incentive to hire an auditor to get a desired opinion on an accounting
matter or on the financial statements as a whole. Second, the successor auditor under
the voluntary auditor change setting is unfamiliar with the new engagement and faces
a high learning curve. DeFond and Subramanyam [1998] suggested that audit quality
decreases in the initial year of audit engagement.
Thus, we propose the following alternate hypothesis for the initial audit
engagement:

H3-1: Audit quality in the initial audit engagement is lower than that in the
subsequent audit engagements.

Proponents of mandatory audit firm rotation have argued that long-term
relationships between auditors and their clients impede auditor independence. In
addition, they have suggested that decreased auditor independence can lead to

auditors’ support for more aggressive accounting choices that push the boundaries of
GAAP and can ultimately result in a failure to detect material fraud and/or
misstatements. They have argued that mandatory rotation enhances auditor
independence because managers cannot directly threaten auditors with their dismissal
and cannot promise future income arising from their continued appointment.
On the other hand, opponents of such rotation have questioned whether rotation
itself would reduce the incidence of audit failures because new auditors are invariably
unfamiliar with their clients and need time to acquire the relevant information and
know-how to effectively audit firms. They have argued that audit failures typically

15
occur in the first year of a mandate and that an auditor better understands the client’s
business, control risks, and other factors that contribute to audit failures as auditor
tenure increases.
Based on these two conflicting predictions, it is not clear whether an increase in
skepticism can overcome the hazards of a new engagement. Thus, it would be of
interest to empirically test the overall effect of mandatory audit firm rotation on audit
quality. In this regard, we propose the following hypothesis in the alternate form:

H3-2: Audit quality in the initial audit engagement under the mandatory
auditor regime is lower than that under the voluntary auditor change
regime.

The prior discussion assumes that auditors do not respond to the mandatory audit
firm rotation requirement. However, auditors under the mandatory audit firm rotation
regime participate in the bid with full recognition that they need to develop detailed
knowledge of a company’s business, its risks, and its constantly changing external
and internal environment. Auditors accept an audit engagement only if they are
willing to take considerable time to achieve full effectiveness. Thus, auditors are
expected to make additional efforts under the mandatory auditor regime, which

should reduce the adverse effect of mandatory audit firm rotation on audit quality. It
would be of interest to empirically test whether audit quality deteriorates in the
mandatory audit firm rotation regime after controlling for audit efforts.


4. Research Design

4.1 Measures of Audit Hours, Audit Fees, and Discretionary Accruals
4.1.1 Measures of Audit Hours and Audit Fees
The scarcity of empirical findings on audit efforts has been primarily due to the
unavailability of large data sets on audit hours. Prior research has collected data on
audit hours via either questionnaires (Palmrose [1989]; O’Keefe et al. [1994]) or
confidential sources (Davidson and Gist [1989]; Deis and Giroux [1996]). One
exception is Caramanis and Lennox’s [2008] study, which used a database of audit

16
hours from 9,738 audits in Greece between 1994 and 2002. Their study is notable in
that its sample consists of large-scale data on audit hours for a reasonable timeframe
in the private sector.
Until recently, audit fees have been confidential in most countries. Thus, early
studies obtained audit fee data through questionnaires. Simunic [1980], Palmrose
[1986], and Francis and Simon [1987] mailed questionnaires and collected audit fee
data. Maher et al. [1992] obtained data on external audit fees and internal audit costs
from the Michigan database, a collaborative effort by a nonrandom sample of
companies who agreed to participate in a study of internal auditing for 1977 and 1981.
Recent studies (DeFond et al. [2002], Abbott et al. [2003]) have obtained audit fee
data from proxies filed with the SEC since the SEC established a rule requiring fee
disclosure for proxies filed on or after February 5, 2001.
Korea provides a good research setting for collecting and analyzing data on audit
hours and fees. Korean companies are required to disclose such data in the annual

reports filed with the FSS. In this study, we conducted cross-sectional analyses,
employing 5,557 audits in Korea from 2000 to 2007, by using audit hours, audit fees
and earnings quality from annual reports. The data have two merits, clearly
distinguishing the present study from many previous studies. First, we used data on
actual audit hours and fees. This made a survey unnecessary and eliminated potential
problems arising from non-response bias. Second, we used both audit hours and audit
fees in one study, complementing each other in examining the effect of mandatory
audit firm rotation.

4.1.2 Measurement of Discretionary Accruals
Audit quality is typically viewed as compliance with Generally Accepted
Auditing Standards (GAAS). Consistent with prior research, here we posit that higher
quality audits constrain the extreme choices of management in presenting the
financial position of the firm. Accruals have been widely used to identify these
extreme reporting decisions (Becker et al. [1998], Myers et al. [2003]). In this regard,
we document the effect of mandatory audit firm rotation on earnings quality by using
absolute, signed, and raw [unsigned] accrual measures as proxies for earnings quality.
Accruals are defined as the difference between cash flows from operations and
net income. Hribar and Collins [2002] argued that a portion of the changes in balance

17
sheet working capital accounts relates to non-operating events and may erroneously
be shown as accruals under the balance sheet approach, possibly leading to an
erroneous conclusion that earnings management exists when there is none. They
recommend that accruals be measured directly from the cash flow statement as
follows:

ACC
CF
t

= EBXI
t
–CFO
t
, (1)

where EBXI
t
is earnings before extraordinary items and discontinued operations and
CFO
t
is operating cash flows taken directly from the statement of cash flows.
We used performance-matched discretionary accruals (DA
adj
) as the measure for
discretionary accruals. Following Tucker and Zarowin [2005], DA
adj
was calculated
as a residual from regression (2) as the regression-based approach, as in Kothari et al.
[2005].
9
To measure the discretionary portion of accruals, we first estimated the
predicted nondiscretionary accruals by using the cross-sectional adaptation of the
performance-matched modified Jones model and then subtracted these predicted
nondiscretionary accruals from the realized accruals. Specifically, we estimated the
following regressions for a given year by using the control firms in the same two-digit
industry code as the firms in the sample:

jtjtjt
jtjtjtjtjtjtjtjt

TAROA
TAPPETARECREVTATAACC












1
3
1211101
/
//)(//
, (2)

where ACC
jt
is accruals in year t for firm j; TA
jt-1
is total assets in year t-1 for firm j;

REV
jt
is revenues in year t less revenues in year t-1 for firm j (i.e., change in

revenues);

REC
jt
is receivables in year t less receivables in year t-1 for firm j (i.e.,
change in receivables); PPE
jt
is property, plant, and equipment in year t for firm j;

jt

is the error term in year t for firm j; and ROA
jt
is the net income in year t for firm j.
We scaled all the variables in regression (2) by total assets in year t-1 to reduce
potential heteroskedasticity. These cross-sectional regressions were re-estimated for


9
Kothari et al. [2005] found that performance-matched discretionary accrual measures enhance the
reliability of inferences from earnings management research.

18
each year in the sample period. The nondiscretionary accruals deflated by the total
assets (NDACC) for the sample firms were computed as follows:

1
3
121110 ///)(/ 





 itjtjtjtjtjtjtjtjt TAROAaTAPPEaTARECREVaTAaNDACC
,
(3)

where
0a
,
1a
,
2a
, and
3
a
are the estimated coefficients from regression (3). The
discretionary accruals (DACC) were computed as the difference between realized
accruals scaled by prior-year total assets and NDACC.

4.2 Model Specification
4.2.1 Audit Hours Model
We used the following model to test the hypotheses on audit hours.

LAH
jt
=


+


1
INITIAL
jt
+

2
INITIAL
jt
 MAN_ROT
jt
+

3
LagLAH
jt
+

4
LTA
jt

+

5
BIG
jt
+

6

CA_CL
jt
+

7
LEV
jt
+ e
jt
, (4)
where


LAH
= the natural log of audit hours,
INITIAL
= 1 if an audit was an initial engagement and 0 otherwise,
MAN_ROT
= 1 if a firm changed its auditor as a result of the auditor
rotation requirement and 0 otherwise ,

LagLAH
= the log of lag audit hours,
LTA
= the natural log of total assets,
BIG
= 1 if a firm was audited by one of Big N audit firms and 0
otherwise,

CA_CL

= the current ratio (current assets ÷ current liabilities),
LEV
= the ratio of long-term liabilities and debt to total assets.

The coefficients of interest were

1
, the coefficient of INITIAL, and

2,
, the
coefficient of the interaction term between INITIAL and MAN_ROT. We expected
that the coefficient estimate of

1
would be positive. The coefficient estimate of

2

was of primary interest because it allowed the determination of whether there were

19
differential audit efforts for new audit engagements imposed by the mandatory
rotation requirement.
Our model of audit hours is based on O’Keefe et al. [1994] and Caramanis and
Lennox [2008]. They showed that client size is the most important determinant of
audit hours. Thus, we controlled for the log of total assets (LTA). We controlled for
client complexity by using the ratio of current assets to current liabilities, and we
controlled for audit risk by using the leverage ratio (LEV). Finally, we included year
dummies and industry dummies for each two-digit sector.

There is no extant evidence of how actual hours vary across audit firms because
prior research has either obtained data from questionnaires or used internal data from
a single Big audit firm. Thus, we included a dummy variable (BIG), which equals one
if the audit firm is performed by one of the Big N audit firms and zero otherwise. We
also replaced BIG by dummy variables for Ernst & Young (EY),
PricewaterhouseCoopers (PWC), Arthur Andersen (AA), KPMG (KPMG), and
Deloitte & Touche (DT).

4.2.2 Audit Fees Model
We used the following model to test the hypotheses on audit fees. The
multivariate regression is as follows:

LAF
jt
= β

+ β
1
INITIAL
jt
+ β
2
INITIAL
jt
 MAN_ROT
jt
+ β
3
IV_LAH
jt

+ β
4
LTA
jt

+ β
5
BIG
jt
+ β
6
SUB
jt
+ β
7
FRGN
jt
+ β
8
AR_INV
jt
+ β
9
ROI
jt
+ β
10
LOSS
jt

+ β
11
OPINION
jt
+ β
12
TELE
jt
+ β
13
UTIL
jt
+ β
14
IND_SPEC
jt

+ β
15
POWER
jt
+ u
jt
, (5)
where


LAF
= the natural log of the audit fee,
IV_LAH

= an instrumental variable measured by the natural log of audit
hours estimated from the audit hours model,

SUB
= the square root of the number of subsidiaries,
FRGN
= the proportion of foreign subsidiaries to total subsidiaries,
AR_INV
= the proportion of total assets composed of inventory and
receivables,

ROI
= return on investment (net income ÷ total assets),

20
LOSS

= 1 if the company reported an operating loss in each of the
past two years and 0 otherwise,

OPINION
= an indicator variable equal to 1 if the firm received a going-
concern modification in the prior year and 0 otherwise,

TELE
= 1 if a firm operated in a telecommunication industry and 0
otherwise,

UTIL
= 1 if a firm operated in an utility industry and 0 otherwise,

IND_SPEC
= 1 if an auditor had 25 (33.3) percent or more market share in
an industry in each year and 0 otherwise,

POWER
= the natural logarithm of each company’s sales divided by the
sum of industry sales for all firms in the industry audited by
the company’s auditor.


The INITIAL variable was coded as 1 if an audit was an initial engagement and 0
otherwise. Simon and Francis [1988] found that there is a significant fee reduction in
the initial engagement. H2-1 predicts that the coefficient estimate of β
1
is negative or
non-positive. The MAN_ROT variable was coded as 1 if an auditor change occurred
as a result of the mandatory rotation requirement and 0 otherwise. MAN_ROT was the
variable of primary interest because it allowed the determination of whether there was
the pricing of new audit engagements imposed by the mandatory rotation requirement.
We included the instrument variable IV_LAH in the full model to address the
endogeneity issue. First, we regressed the log of audit hours at t (LAH
jt
) with respect
to log-lagged audit hours at t-1 (LAH
jt-1
) with control variables in the regression. We
expected strong persistence in audit hours, which would make lagged audit hours a
powerful predictor of current audit hours. In addition, LAH
jt-1
was expected to be

uncorrelated with u
jt
. Second, we obtained the predicted (instrumented) log of audit
hours (IV_LAH
jt
) by using the coefficient estimates in the first regression.
The control variables included in our analysis were drawn from a large body of
research on audit fees (Casterella et al. [2004], Huang et al. [2007]). We included the
LTA variable, the natural log of total assets, because larger client firms were expected
to require more audit effort and consequently higher audit fees. We included the Big
N indicator variable (BIG) to represent the high-quality audit service provided by Big
N auditors, which was expected to influence audit fees (Francis and Simon [1987]).

21
We controlled for client complexity by including the square root of the number of
subsidiaries (SUB) and the proportion of foreign subsidiaries to total subsidiaries
(FRGN). AR_INV measures the proportion of total assets in inventory and accounts
receivable. Because the audit fee is positively related to client size, client complexity,
client-specific risk factors, and high-quality service, we predicted all these
coefficients to be positive.
Prior research has controlled for the client’s financial status and risk profile. We
used an indicator variable (ROI), return on investment, to measure profitability. We
also employed another indicator variable (LOSS) to capture client-specific litigation
risks. LOSS was coded as 1 if the client reported a net loss and 0 otherwise. OPINION
was coded as 1 if the client received a going concern modification in the sample year
and 0 otherwise. We further controlled for industry characteristics by including TELE
(telecommunication industry) and UTIL (utility industry) dummy variables (Huang et
al. [2007]). In addition, auditor industry specialization (IND_SPEC) and client
bargaining power (POWER) were included.

4.2.3 Discretionary Accruals Model
We used the following model to test the hypotheses on audit quality. Our model
specification is as follows:

DA
jt
=


+

1
INITIAL
jt
+

2
INITIAL
jt
 MAN_ROT
jt
+

3
IV_LAH
jt
+

4
LTA

jt

+

5
BIG
jt
+

6
AGE
jt
+

7
OCF_TA
jt
+

8
IND_GRWTH
jt

+

9
CA_CL
jt
+ v
jt ,

(6)
Where


DA
= Discretionary accruals,
AGE
= the number of years after establishment,
OCF_TA
= the ratio of operating cash flows to total assets,
IND_GRWTH
=


N
i
it
Sales
1
/



N
i
it
Sales
1
1
by two-digit SIC code.

The coefficients of interest were

1
, and

2
. DeFond and Subramanyam [1998]
found that discretionary accruals are income-decreasing during the last year with the
predecessor auditor. Our key variables were INITIAL, which was coded as 1 if an

22
audit was performed by a predecessor auditor, and MAN_ROT, which was coded as 1
if an initial engagement occurred as a result of the mandatory rotation requirement.
The instrument variable IV_LAH was measured as described in 4.2.2.
The control variables in our analysis were drawn from Myers et al. [2003].
Client size is positively related to abnormal accruals (Becker et al. 1998]. Thus, we
included client size (LTA) as a control variable. We included the Big dummy variable
to control for differences in earnings management between Big N and non-Big N
client firms (Becker et al. 1998). We included AGE because accruals differ with
changes in the firm’s life cycle (Anthony and Ramesh [1992], Dechow et al. [2001],
Myers et al. [2003]). OCF_TA was included because firms with higher cash flows
from operations are more likely to be better performers (Frankel et al. 2002) and
because accruals and cash flows are negatively correlated on average (Dechow [1994],
Sloan [1996], Myers et al. [2003]). We controlled for IND_GRWTH because growth
in the industry should be positively correlated with accruals (Myers et al. [2003]).
Butler, Leone, and Willenborg [2004] found a positive relation between discretionary
accruals and liquidity. Based on their study, we included the current ratio (CA_CL) to
control for liquidity.

5. Empirical Results

5.1 Sample
The sample firms were selected from companies listed on the Korean Stock
Exchange (KSE) and Korea Securities Dealers Automated Quotations (KOSDAQ)
from 2000 to 2007. Initially, a total of 12,463 firm-year observations were obtained
from the KIS value database.
10
Non-December year-end firms were excluded because
their tax change effects could have been different. We also excluded 266 financial
and insurance observations from the sample because of differences in financial
characteristics. We further deleted observations if audit fee, audit hour, and financial
data were not available during the sample period. Firms in the industry with less than
eight member firms each year were also excluded because discretionary accruals were
estimated for each industry and each year by using the cross-sectional modified Jones


10
The KIS value database is provided by Korea Investors Service Inc., which is affiliated with
Moody’s.

23
model (Kothari et al. [2005]). These procedures resulted in the final sample
comprising 5,557 firm-year observations (Table 1). There are more observations after
2005 because the disclosure of audit hours and audit fees has stabilized since it was
made mandatory in 2000.

<Insert Table 1 here>

5.2 Descriptive Statistics

5.2.1 Frequency of Observations with Respect to Initial Audit Engagement, Auditor
Change, Industry, and Year
Panel A of Table 2 reports the frequency of observations for the consecutive
audit and initial audit engagements. Out of 5,557 observations, 4,373 (78.7%)
engagements were consecutive audits, and 1,184 (21.3%) were initial audits. Roughly
speaking, one out of five was an initial audit engagement. Of these 1,184 initial
engagements, 1,010 observations were classified as voluntary auditor change. The
remaining 174 engagements were due to auditor change based on the mandatory audit
firm rotation requirement.
Panels B of Table 2 presents the frequency of predecessors and successors for
the 174 engagements. Out of 112 Big audit firm clients, 86 clients (76.8%) chose
another Big audit firm, and the remaining 26 clients (23.2%) chose a non-Big audit
firm. On the other hand, of the 62 non-Big clients, 27 clients (43.5%) switched to a
Big audit firm, and only 35 clients (56.5%) chose a non-Big audit firm. This indicates
the increased concentration of Big N audit firms. This is inconsistent with the recent
argument by Economist [2004] that mandatory audit firm rotation can be a
mechanism to mitigate the dominance of Big N audit firms in the market for public
companies.
Panel C presents the frequency analysis (the net gain or loss of clients for each
audit firm). For example, PWC lost 42 clients but gained 26 clients after the
mandatory audit firm rotation. Thus, PWC experienced 16 losses. Other than PWC,
all the Big audit firms gained clients from the rotation requirement. The biggest
winner was Deloitte Touche, which had a net gain of 10 clients. Non-Big audit firms
lost 62 clients and gained 61 clients, indicating that the effect of mandatory audit firm
rotation on gaining clients was minimal.