Eur J Law Econ (2015) 40:225246

DOI 10.1007/s10657-012-9361-0

The link between in- and external rotation

of the auditor and the quality of financial accounting
and external audit

Patrick Velte Carl-Christian Freidank

Published online: 30 October 2012

Springer Science+Business Media New York 2012

Abstract The European Commission (EC) regulation draft of 2011 contains the
external mandatory auditor rotation (audit firm rotation) as a reform measure to
increase auditor independence. The external auditor firm rotation could supplement
the internal mandatory rotation (auditor rotation) by the 8th EC directive. This
article presents an agency theoretical foundation of rotation. In this context, the
main influences on low balling and on the expectation gap will be presented. The
total effect of the rotation on financial accounting and audit quality is theoretically
uncertain, because the rotation can also lead to a decreased independence in a low
balling situation and is connected with interrupted or lost learning and knowledge
effects by the auditor or the audit firm. Then, a state of the art analysis of empirical
research results with regard to auditor and audit firm rotation is focused. In contrast
to the assumption of the EC, the majority of the empirical results dont lead to an
increased financial accounting and audit quality by audit firm rotations. Further-
more, the positive effects of the internal rotation period of 7 years and the cooling
off period of 2 years by the 8th EC directive are not empirically proved yet.

Keywords Low balling
Expectation gap
Audit quality

Empirical audit research
Accounting policy
Auditor independence

JEL Classification M4
H1
K2
G3

P. Velte (&)
C.-C. Freidank

School of Business, Economics and Social Sciences, Department of Business Administration,
University of Hamburg, Max-Brauer-Allee 60, 22765 Hamburg, Germany
e-mail: Patrick.Velte@wiso.uni-hamburg.de

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1 Introduction and European auditor reform measures

The European Commission (EC) plans to reform the professional standards of

accountants and auditors in a regulation draft (EC 2011). This reform measure is a
reaction to the capital markets reduced reliance in the decision usefulness of
financial accounting and auditing after the financial crisis. The EC tries to increase
audit quality by reducing the expectation gap (see Liggio (1974)), increasing auditor
independence and preventing further audit market concentration (Freidank and
Velte 2012). Based on actual autonomy (auditor independence in fact) as well as on
autonomy perceived as such by the capital markets (auditor independence in
appearance), the EC regulation draft contains several reform measures to strengthen
auditor independence (Ruhnke (2012); Velte and Sepetauz 2012).
The implementation of a mandatory external rotation as well as the separation of
audit and non-audit services represent the two major reform measures for
strengthening auditor independence. So far, the EC did not stipulate explicitly the
prohibition of services with regard to the compatibility of audit and non-audit
services on the lines of the US SarbanesOxley Act and the EC recommendation
(EC 2002). In fact a principle based approach has been applied. Up to now, legal
and tax consultancy services are allowed parallel to audit taking into account the
self-review prohibition. According to article 31 of the EC regulation draft of 2011,
all expert services unrelated to the audit, tax consulting, general management and
other advisory services as well as legal services are prohibited in general, provided
that the audit is carried out at the client at the same time. Another novelty of major
importance is the general prohibition of all non-audit services where an audit firm
generates more than one third of its audit fees from large public-interest entities and
belongs to a network whose members have combined audit fees which exceed 1,500
million within the EU.
This paper does not mainly address the aforementioned reform measures
regarding the separation of audit and non-audit services, but primarily focuses on in-
and external rotation. While internal rotation (auditor rotation) represents an auditor
change within the audit firm, external rotation is connected with a replacement of
the whole audit firm (Weber 2005, p. 880). There is only one EU-member state with
audit firm rotation (Italy since 1974), which, however, was not able to prevent the
financial fraud scandal at Parmalat (Quick 2004, p. 499). Austria introduced external
rotation for financial years beginning on January 1, 2004, but abolished it before it
came into effect (Doralt 2008, p. 419). The obligation of audit firm rotation has also
finished in Greece and Spain. Based on the 8th EC directive, only all responsible
partners of auditing companies have since been obligated to submit to an internal
rotation by 7 years. After a cooling off period of 2 years, the auditor in charge may
reapprove their services with a given client (Pingel 2007, p. 200). According to
article 10 of the EC regulation draft, the present internal rotation with an increase in
the cooling off period by 1 year is to be accompanied by an external rotation after
6 years with a cooling off period of 4 years. The client may request for a 2 year
extension of the audit mandate in exceptional cases. In case of a joint audit, the
rotation period is extended to 9, 3 years respectively upon request of the company.
In order to limit the transaction costs of a new auditor in case of a rotation, the

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leaving auditor is requested to prepare a hand-over report according to the

regulation draft. In addition, the minimum duration of a first mandate has been set to
2 years, whereas so far a yearly reelection of the annual auditor was needed,
banning a multi-year auditor contract. Table 1 shows the differences between the
8th EC Directive and the EC recommendation on the one hand and the current EC
reform draft to strengthen auditor independence on the other hand.
The ECs considerations to introduce a mandatory external audit were already
outlined in a draft directive dated February 17, 2004, regarding an amendment to the
8th EC directive (EC 2004) which was giving the option to choose between internal
rotation after 5 years and external rotation after 7 years (Schildbach 2004, p. 264).
Upon passage of the modified 8th EC directive, audit firm rotation was not codified
due toaccording to the ECs assessment thennegative effects on audit quality
were expected. At the same time, the US capital market was considering introducing
compulsory external rotation in compliance to the SarbanesOxley Act (2002).
Consistent with the ECs opinion of that time, however, the results of an empirical
survey by the General Accounting Office (GAO 2003), objected to compulsory
external rotation. As a substitute, an internal rotation cycle of 5 years as well as a
cooling off period of 2 years according to Section 203 of the SarbanesOxley Act
was introduced for all auditors who are primarily responsible for the mandate at
hand or in charge of an internal revision of audits, and provided audits for clients in
question (Schmidt 2003, p. 785). For all non responsible auditors in charge of
crucial cases who are in regular contact with the companys administration, an
extended rotation period of 7 years, followed by a cooling off period of only 1 year
is to be observed. In Switzerland, according to Article 730a Paragraph 2
Obligationenrecht, compulsory internal rotation followed by a 3 year cooling-
off period is to be adhered to (Sanwald and Huser 2009, p. 461).
This article mainly deals with the results of empirical audit research regarding
effects of auditor- and audit firm rotation on financial accounting- and audit quality
because the EC reform plans are very controversial. The ECs assumption of a
positive link between rotation on the one hand and accounting and auditing quality
on the other hand has to be questioned. We try to present a sound theoretical
background of rotation as well as a proper review of empirical audit research.
Chapter 2 contains an agency theoretical foundation of rotation with special
consideration of low balling (2.2) and expectation gap (2.3). In the next step,
empirical audit studies are presented, distinguishing between internal and external
rotation as well as the effects of rotation on quality of financial accounting and audit
(3.1 and 3.2). Chapter 4 summarizes the results.

2 In- and external rotation in the principal agent theory

2.1 The role of the external auditor in the corporate governance system

According to the two tier principal agent theory based on Tirole (1986), external
audits are an incentive to strengthen public trust in financial accounting. External
audit is a monitoring and bonding instrument for management activities and is

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Table 1 Main reform measures of the EC regulation draft of 2011 in order to increase auditor
independence
8th EC Directive of 2006/EC
recommendation of 2002
Internal rotation
Change period: 7 years
Cooling off period: 2 years
External rotation
Separation of audit and non-audit services
No financial or commercial
relations, employments or
other relations to the client
that may affect
independence
In case of self-review or self-
interest no additional
services, if risks are
significant compared to the
taken protective measures
to secure independency
Preparation of accounting
documents and annual
financial statements
Development and
implementation of financial
information systems
Participation in internal
auditing
Settlement of legal dispute
Hiring of senior management
for the client
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Eur J Law Econ (2015) 40:225246
EC regulation draft of 2011
Change period: 7 years
Cooling off period: 3 years
Principle: Obligation after 6 years (single audit), 9 years respectively (joint audit)
Exception: extension at the request of the client for 2 years (single audit), 3 years
respectively (joint audit)
Cooling off period: 4 years
Preparation of a hand over report of the leaving auditor
Minimum duration of two years for fist mandate
Prohibition of all non-audit services as referred to in article 10, paragraph 3a:
expert services unrelated to the audit, tax consultancy, general management and other
advisory services;
bookkeeping and preparing accounting records and financial statements;
designing and implementing internal control or risk management procedure related to
the preparation and/or control of financing information included in the financial
statements and advice on risk
internal auditing and associated services
valuation services, providing fairness opinions or contribution-in-kind reports
actuarial and legal services, including the resolution of litigation;
designing and implementing financial information technology systems for public-
interest entities
broker or dealer, investment adviser, or investment banking services.
General prohibition of all non-audit services as referred to in article 10, paragraph 3b:
Human resources services (exception: approved by audit committee)
providing comfort letters for investors in the context of the issuance of an undertakings
securities (exception: approved by audit committee)
designing and implementing financial information technology systems for public-
interest entities (exception: approved by regulatory authority)
Due diligence services (exception: approved by regulatory authority)
General prohibition of all non-audit services where an audit firm generates more than
one third of its annual audit revenues from large public-interest entities and belongs to
a network whose members have combined annual audit revenues which exceed 1 500
million within the EU
Duty to disclose when the total fees received from a public-interest entity subject to the
statutory audit represent either more than 20 % or, for two consecutive years, more
than 15 % of the of the total annual fees received by the statutory auditor or audit firm
carrying out the statutory audit
When the statutory auditor or audit firm provides to the audited entity related financial
audit services, as referred to in Article 10(2), the fees for such services shall be limited
to no more than 10 % of the fees paid by the audited entity for the statutory audit
Eur J Law Econ (2015) 40:225246 229

meant to motivate legally sound and orderly financial accounting (Chow 1982,
p. 274). The audit constitutes an action delegated by the investors of a company in
terms of a principal agent relationship. It is made necessary by the investors lack of
time and professional resources and the rational apathy in the publicly owned firm
(Watts and Zimmerman 1983, p. 614 f.). The relationship between auditor and
capital market is reflected in the gatekeeper function according to Kraakman (1986)
and Coffee (2006). Also, the auditor is meant to support the supervisory body or
audit committee in supervising the management (assistant role) (Freidank et al.
(2009); Velte (2010), p. 451 f.; Velte and Weber (2011), p. 225).
Since, according to Antle (1982), the auditor is an economic agent, he can be
attributed the classic agency conflicts of hidden characteristics, -information, -action
and -transfers, resulting in the risks of adverse selection and moral hazard (Herzig
and Watrin 1995, p. 786). The principal agent issues an auditor faces may impair his
ability and freedom to make a sound assessment (Stegemeyer 2002, p. 100102).
Adverse selection may be the result of an auditors lack of qualifications on the one
hand, or his bias towards the audited company on the other hand. In addition to this
pre-contractual principal agent conflict, post-contractual information asymmetries
pose the danger of a moral hazard due to improper audits (shirking) and assessments
(Quick (2002), p. 630). There is also the possibility of a moral hazard if the auditor
and management collaborate. In such a case, the auditor might tolerate faulty
financial accounting and grant an unqualified audit opinion in exchange for hidden
transfer benefits. Since an auditors compensation is not fully transparent for the
capital market, incurring the risk of hidden actions, there is a danger of biased
judgment by the auditor (see Leffson (1988), p. 6786) and untruthful reporting on
the outcome of the audit (Herzig and Watrin (1995), p. 793).

2.2 Low balling and auditor changes

2.2.1 Basics

The traditional agency models neglect auditor changes, with extreme cases allowing
for indefinite mandates (Ewert 2003, p. 535). The risks of an asymmetrical
distribution of information in audits can be magnified through the low balling
phenomenon. Low balling indicates that the audit fees for the initial mandate as
negotiated with the client do not cover the actual costs. This strategy can have a
negative impact on auditor independence and lead to higher incentives to form a
coalition with the management (DeAngelo 1981a). According to the basic model of
DeAngelo (1981a), the first audit will cause start up costs because the auditor will
have to first familiarize himself with the business activities and environment of the
company (empirical evidence e.g. by Ridyard and DeBolle (1992)). Still, the auditor
chooses a low balling strategy to crowd competitors out. These losses of the first
audit represent a market entry barrier for competing auditor firms. The learning
effects in follow up audits, which reduce audit costs, are stated empirically e.g. by
Rubin (1988) and Roberts and Glezen (1990). These information and cost
advantages are an additional market entry barrier in later audit cycles (Quick
(2002), p. 628).

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Fee cutting, which implies a continuous increase of auditor fees through

strategic market considerations has a positive effect on quasi rents and strengthens
the incentives for low balling. A lack of fee cutting, however, does not necessarily
mean that a low balling strategy was not utilized. Reversely, the presence of fee
cutting is not necessarily evidence of a low balling strategy. At first, fee cutting
could not empirically be proven (Palmrose 1982, 1986; Rubin 1985; Simunic
1980). Since the late 1980s evidence has increased (e.g. Ettredge and Greenberg
1990; Turpen 1990; Gregory and Collier 1996; Craswell and Francis 1999). In
recent years, fee cutting is less attractive for audit firms with regard to mandatory
declarations in the notes (e.g. in Germany 285 No. 17 Handelsgesetzbuch
(HGB)), and in the transparency report of audit firms ( 55c Wirtschaftspru-
ferordnung (WPO)). Audit fee reporting enables the identification of fee cutting
by the investors. But empiric measuring of low balling is more difficult, since the
self costs of audit firms in the initial audit are not reconstructible for clients
(Simons 2011, p. 162). Marten (1994) had assumed a tendency to low balling on
the basis of a survey among German auditors. Schatzberg (1990), Schatzberg and
Sevcik (1994) and Schatzberg et al. (1996) had found evidence of low balling
through experiments, only.
Based upon De Angelos basic model (1981a), Beck et al. (1988) concentrate on
combining audit and consulting services. Non audit duties can lead to an increased
low balling effect when the auditor evaluates the financial accounting at the same
time due to spillover effects. The absolute economic advantage of the auditor is
greater than if he limited his services to audits if the sum of training costs for the
consultant and the consulting costs are greater than the cost reduction through
auditor training by means of knowledge transfer. Magee and Tseng (1990) add
differences of opinion between client and auditor to the equation. Differences of
opinion originate in a conflict about (non-)acceptance of a certain questionable
accounting policy. The economic advantage of maintaining the auditing assignment
due to positive transaction costs of the change is only incurring a restriction of
independence if differences of opinion are of multi periodical nature, various types
in the auditing industry regarding evaluation of accounting, the client is unable to
distinguish the type of the auditor, and the auditor himself knows his type only after
the election. Le and Gu (1998) argue that auditor independence can be increased by
low balling if the auditor receives his assignment directly from the shareholders and
not from the audit committee. In this scenario, quasi rents are a security deposit
which is immediately withdrawn if malperformance occurs. Although in a stock
corporation, e.g. in Germany, the auditor is elected by the shareholders, the
assignment is awarded by the supervisory board (two tier system). Following Le and
Gu (1998), an accordingly positive effect of low balling only occurs if the
supervisory board acts on behalf of the shareholders at all times, is independent
from the management, and possesses appropriate financial expertise. A long-term
assignment is equally necessary in order to extend quasi rents, upon which a re-
election of the auditor is to be expected. From a German point of view there is
normative restriction based on the auditors internal rotation cycle and the necessity
of annual re-election.

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2.2.2 Advantages of mandatory rotation

According to the EC, internal and external rotation can enhance audit quality due to
prevention of auditor dependence, distinguishing between the auditing of capital
market oriented and non-capital market oriented corporations. The necessity of a
statutory rotation is solely related to large management operated corporations,
because traditional agency conflicts are characteristic in this group. Shareholders in
small and medium-size companies have greater influence on the management than
an average private shareholder in a public company.
A fundamental approach to the economic impact of auditor changes was
presented by Burton and Roberts (1967). In a stock corporation, the assistant role of
an auditor to support the supervisory board or the audit committee becomes more
and more important. Although, a long-term contract between client and auditor
seems sensible, the independence in appearance might be limited due to a special
trust relationship between management and auditor in a long-term assignment.
Burton and Roberts (1967) state that personal relationships between auditor and
management, the combination of audit and non audit duties, as well as the auditors
intention of maintaining the assignment are determining factors towards reducing
audit quality.
According to DeAngelo (1981a), quasi-rents according to low ballingwithout
compulsory rotationcan lead to higher financial incentives to give up the
independence of the auditor, if the probability of exposure by the investors is low.
Insofar, low balling which is connected with a lack of independence can be
prevented by mandatory rotation (Ewert (2003), p. 536). Chi et al. (2004) refuse this
opinion and state an adverse effect on independence in fact due to rotation under the
existence of quasi rents and assignment by the owners. It is pointed out that the
auditor would give up his independence in the last audit period before the rotation
because he assumes hidden transfers of the management since he no longer has to be
concerned about the loss of quasi rents due to shareholders not being re-elected.
According to Bigus and Zimmermann (2007), the absolute (client related), but not
necessarily the relative quasi rents are cut short due to rotation, which implies that
rotation does not necessarily cause an increase of auditor independence.
Finally, literature assumes stricter and more relentless audit under rotation rules,
because the auditor intents to diminish the risk of having his successor complain
about his low performing upon review of previous years audits (Ewert 2003,
p. 536). The avoidance of organizational blindness (Leffson 1988, p. 115) under
rotation is pointed out, as negatively influencing the audit efficiency, even under
observation of independence. Hence, the auditor simply trusts his results from
previous years instead of anticipating important changes in the company develop-
ment and adjusting his auditing strategy.

2.2.3 Risks of mandatory rotation

The advantages of mandatory rotation with regard to low balling are not secured
because of system immanent disadvantages (see Ewert 2003, p. 536). An auditor
change incurs higher audit costs and audit fees which result in additional costs of the

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initial audit and transaction costs for the management (Herzig and Watrin 1995,
p. 795; Velte 2011, p. 318). Especially long-term audit scheduling and following up
on complaints or auditors suggestions from previous audit periods would have to
suffer under rotation (Luik 1976, p. 239). US studies show that the auditors risk of
liability is significantly higher in first or second audits than in the following periods
(AICPA 1992). Since first audits tend to be of lower quality, negative responses of
the capital market are to be expected upon a forced change of auditor. An investor
cannot distinguish a voluntary or forced auditor change (opinion shopping of the
management) from a regulative rotation, leading to increased cost of information
(Bigus and Zimmermann 2007, p. 19). Therefore, for corporations which aim to
offer high audit quality to the capital market, compulsory rotation in short intervals
may be unfavorable (signaling, see Spence 1973). Even a statutory long-term
rotation cycle (e.g. more than 9 years) cannot prevent the risk of hidden intention of
management.
Another important disadvantage of compulsory rotation is audit market
concentration. The European audit market for listed companies is dominated by
few big audit firms. According to DeAngelo (1981b), having the highest experience
value in audit capital market oriented enterprises, they are related to a higher quality
and independence, and have an extensive potential to offer a range of additional
services. This oligopolization of the European audit market crowds small and
medium-sized audit firms out of the market. These difficulties cannot be prevented
by compulsory rotation, since changes are made within the audit firm (internal
rotation) or between big audit companies (external rotation). Furthermore, practical
experience suggests frequent changes from small to larger audit companies (Quick
2004, p. 490). The impacts under rotation by a change of the audit company as
opposed to a change of auditor within the company are stronger. The overall impact
of compulsory rotation is, from a theoretical point of view, not explicit, therefore,
even with the auditor applying low balling, a rotation does not necessarily imply
higher quality but the interruption or shortfall of learning and experience effects can
have an altogether negative effect on the quality of financial accounting and audit.

2.3 Expectation Gap

The necessity of rotation rules is related to a decrease of the expectation gap (see
Velte 2009, p. 481483), in addition to its effects on low balling. The term
expectation gap is based on the empirical results of the Commission on Auditors
Responsibilities (CAR 1978) of the American Institute of Certified Public
Accountants (AICPA). The expectation gap can be explained by the principal
agent theory and the associated information asymmetries and conflicts of interest
between client, auditor and stakeholders. Corresponding agency problems may have
severe effects on the economic use of the annual audit for the stakeholders. The
expectation gap which the EC acknowledges as a substantial problem measures the
discrepancy between investors understanding of extent and purpose of the audit and
the actual processing by the auditor. In Germany, the expectation gap was
empirically first established by Hunger (1981) and recently by Ruhnke et al. (2010).
Surveys by Lin and Chen (2004) and Gay (2007) show that investors, among other

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things, assume an supervision of management by the auditor, an evaluation of the

companys financial solvency, or a general examination of management fraud.
Country specific differences in the expectation gap can also be established based on
various cultural and behavioral parameters and national professional developments,
compare Haniffa and Hudaib (2007) and Moizer et al. (1996). As an approach to a
solution, McEnroe and Martens (2001) and Salehi (2007) suggest, among others, the
modification of audit standards and increase of reporting obligations towards the
public, consistent with recent plans of the EC.
The original definition of the expectation gap by Liggio (1974) into facts that
lead to auditor, norms or public failure has been developed further to the
components shown in Fig. 1. Since there is an overlap of the corresponding
contents, a selective classification is impeded.
The accounting gap represents the quantitative differences between the
expectations of the stakeholders regarding audit quality and audit performed
conforming to the law. In this connection a risk of misinterpretation exists regarding
the auditors complete evaluation of the financial accounting. Yet, the auditor uses
system audit and random samples audit in line with the materiality principle,
allowing for a lean auditing and positive rationalization effects. In turn, the risk of
an increased accounting gap rises. Internal audit by the supervisory board is also
checking on expedience and economic efficiency, whereas external audit is limited
to a legal and truth and fairness evaluation in general. The auditor is requested to
report on the limited scope of audit in the certificate to the stakeholders. Yet, they
may take the erroneous assumption that an unqualified opinion with regard to the
audit represents a future oriented seal of approval for the management.
As a second component of the expectation gap, the performance gap unlike the
accounting gap is measuring the qualitative rather than the quantitative unrealistic
expectations regarding the quality of the audit. The concrete organization of the
internal and external quality management of the annual audit is of major
importance. Another substantial determent is represented by the principle of
independence of the annual auditor. The planned measures in the EC regulation
draft of 2011 are affected as well.
As the third component of the expectation gap, the reporting gap is directed at the
external reporting of the auditor in public, also potentially giving rise to unrealistic
expectations with regard to the actual quality of the audit. As a general rule, the
auditors report is for the attention of the supervisory board, legal representatives
respectively only and hence cannot be reviewed externally. In contrast, the auditors

expectation gap

accounting gap performance gap reporting gap

quantity quality notes

Fig. 1 Components of the expectation gap

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opinion is designed more formalistic. The reporting gap of voluntary audits is

especially pronounced for example in case of sustainability reports, not being part of
the legal mandatory audit. Potential misinterpretations by the public may result from
missing sensitivity and insufficient separation regarding the different subjects of the
audit. With the regulation draft of 2011, the EC intends to enlarge the contents of
the auditors opinion significantly and to introduce minimum contents of the
auditors report.
An evaluation of the EC regulation draft indicates that not only investors but also
the regulator, in this case the EC, have high expectations regarding the performance
of the annual auditor. Hence, audit is expected to ensure financial stability, yet the
legal obligation regarding the audit is limited to a truth and fairness evaluation of
financial accounting. As a result, the auditor is neither responsible for any kind of
accounting scandal of the management nor for a cash-out or insolvency of the
company in question. Hence it is to be questioned in how far the reform measures of
the EC regulation draft contribute to the increase instead of the intended decrease of
the expectation gap. Thus, making the differentiation between observable and
verifiable information of incomplete contracts inevitable in the context of
information economy (Arrunada (1999, 2000)). In order to draw conclusions from
the auditing, the annual auditor may use hard or soft information. Hard
information refers to information that is observable and verifiable by the investors,
whereas soft information refers to information that is observable but not
verifiable. In case of an expansion of the audit regulations by the legislator (e.g.
more restrictive requirements regarding the independency), leading to an additional
workload, the auditor will only base his judgment on the hard information as a
result of the increase in objectivity and not use the soft information (defensive
audit). Yet, the risk of an incorrect audit opinion rises as a result of the reduced
amount of available information (Arrunada (1999)). Accordingly, the degree of
regulation of the audit norms has an effect on the information processing of the
auditor. As a conclusion, the tendency to intensify audit regulation as suggested by
the EC regulation draft, is to be seriously questioned.
Following Weienberger (2003), the impact of rotation on the expectation gap
depends on the audit performance representing an experience- or confidence value.
In case of experience values which occur under long-term assignments, external
auditor rotation extends the expectation gap. This is due to a deviant and, from the
capital markets viewpoint, unstable quality of auditing caused by a change of
auditors. If, after an extended assignment, an external rotation takes place, the audit
performance advances from experience value to confidence value. Weienberger
(2003) assumes that, while rotation tends to result in greater independence of
auditors, at the same time it reduces the quality of auditing. The positive effects on
the independence of auditors, however, incur the risk of future undercapitalization,
as compulsory rotation makes the development of client or industry specific
information less appealing to the auditor. However Quick (2004), among others,
critically reviews Weienbergers (2003) model assumptions and insinuates their
being of limited informative value. Likewise, other theoretical studies, e.g.
Arrunada and Paz-Ares (1997) und Summer (1998), basically result in a rejection
of compulsory external rotation. The following is to examine to what extent these

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diverging opinions regarding the effect of rotation on low balling and the
expectation gap are backed by recent results of empirical audit research.
Therefore, the efforts of the EC should be addressed primarily at demonstrating
the range and limits of the external annual auditing towards the investors. As a
result, a reform of the reporting of the auditor to the public (auditors opinion) is
advised, justifying the report in question by adding additional information on the
preparation and operation of the auditing as well as on its restrictions. A
disproportional increase in the regulations regarding the auditors independence
with the introduction of an external rotation is to be viewed critically from an
information theoretical perspective, since the annual auditor would not consider
information that cannot be verified by the investors (defensive audit).

3 Empirical results of audit research

3.1 Effects of auditor rotation on the quality of financial accounting and audit

3.1.1 Increase

Empirical auditor change research is dominant mainly on the US, Asian and
Australian capital market (see Fischkin and Gassen 2011; Stefaniak et al. 2009; Pott
et al. 2009). Quality of financial accounting and audit is estimated by various
proxies, which provide limited informational value (Bedard et al. 2008). The extent
of accounting policy is estimated by discretionary accruals (e.g. the models of Jones
1991; DeFond and Park 2001). Investors tend to disapprove of an accounting policy
with maximum results, especially regarding companies in a situation of losses
(Jones 1991, p. 193), the reason being that asymmetric flow of information between
management and investors are encouraged in order to deliberately conceal the actual
economic situation, or, for reasons of image policy, to portray it as being better than
it is. Under a thorough and independent examination, the auditor will scrutinize a
positive image policy more critically and will not tolerate questionable aspects of
accounting. Since, as mentioned above, the risk of collaboration between
management and auditor increases with the duration of the assignment, the
following surveys will establish to what extent a possible enhancement of auditor
independence through rotation might reduce accounting policy and create a more
conservative application of accounting standards. In this context, Chi et al. (2009)
create a positive link between introduction of compulsory internal rotation in
Taiwan in 2004 and quality of financial accounting. Likewise for the Australian
capital market Hamilton et al. (2005) prove in 3,621 cases, observed during the
business years of 19982003, that internal auditor rotation reduces accounting
policy. According to Gates et al. (2007) an experiment among US students shows
that auditor rotation increases investors confidence in the quality of financial
accounting in a regulatory environment with increased corporate governance
procedures. As one among few surveys, Zimmermann (2008) refers to the German
capital market. Based on 102 prime standard companies, an increase of audit fees
(fee cutting) following an extended assignment was obvious. A significant relation

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between the duration of assignment and the level of accounting policy, however,
could not be proven.
Besides the quality of financial accounting, the quality of auditing is determined
by diverging variables, e.g. based on restricted going concern opinions, assuming
that an independent auditor, facing companies with substantial liquidity issues,
decides to restrict or deny the going concern opinion. With rotation, an increased
rate of restricted or denied approval is expected, since the management wishes an
unrestricted attestation and imposes pressure upon the auditor to have him comply.
Using the above mentioned variable, Carey and Simnett (2006) prove that, in the
case of 1,021 Australian enterprises during the business year of 1995, the audit
quality decreases with increasing duration of the assignment and increases with
internal rotation. However there is no proven correlation between the length of an
assignment and the degree of accounting policy as a second variable. Dao et al.
(2008), who surveyed 635 US corporations in the business year of 2006 conclude
that, in long-term assignments, investors realize a decrease of audit quality in a
given time frame, which is reversed by internal rotation. However a fixed schedule
of the rotation and cooling off period with an existing compulsory internal rotation
as outlined in the 8th EC directive, which allows for another assignment of an
auditor after the change, has not been sufficiently researched.

3.1.2 Decrease or lack of proof of an increase

Watrin et al. (2008) analyze the impacts of changing the chief auditor and the
authorizing auditor on the extent of accounting policy in the DAX, MDAX, SDAX,
and TecDAX in the business years of 20042007. While there is no evidence of
significant changes in accounting policy upon change of chief auditor, there are
signs of an increase of earnings-improving accounting policy after a change of the
authorizing auditor. This result is contrary to the efficiency of rotation, since it
implies that the management assumes a lower quality of the initial auditing and
expects a questionable accounting policy to be tolerated by the auditor. According
to Cameran et al. (2008), in the Italian capital market no positive impact can be
detected in 1,439 surveys during business years between 1985 and 2004 regarding
the extent of accounting policy under internal rotation. Blouin et al. (2007) draw an
identical conclusion based on 407 US corporations in the business years of 2001 and
2002.
In addition to the above mentioned variables, the auditor independence is
determined by the audit fees paid, which, in the US as well as the EU, requires the
audited corporation to report in the notes and, in case of capital market oriented
companies, disclosure of the audit firm in the transparency report. In this context
there seems to be an increasing relation between non-audit and audit fees along with
a decreasing independence in appearance, as quasi-rents per client according to low
balling increase with higher additional income, and the auditor can be restricted in
his ability to judge in order to keep his assignment. Based on 4,720 US corporations
during the business years of 2000 and 2001, Gul et al. (2007) point out that the
auditor independence is rather hindered by non-audit fees and a short duration of

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assignment than by an extended cooperation, and that compulsory internal rotation

is counterproductive.
Finally, the survey by Azizkhani et al. (2007) examines the impact of rotation on
the capital markets responses. The management board strives to increase the
company value by decreasing the risk margin on allocated capital contribution.
Reduction of capital contribution depends on the investors confidence in audited
financial accounting, and whether decision relevant information is presented.
According to Azizkhani et al. (2007), in 2,033 Australian corporations during
business years of 19952005 no impact of internal rotation with Big Four audit
companies on the costs of capital has been evident.

3.2 Impacts of audit firm rotation on the quality of financial accounting

and audit

3.2.1 Increase

The following empirical surveys on external rotation mainly relate to the US capital
market. Based on an experimental US-study, Dopuch et al. (2001) stress that in case
of audit without external rotation it is more likely that the auditor over time biases
approval testates accommodating the management, and conceals errors from the
public. In that experiment, however, experience effects of the auditor under a long-
term assignment remain uncovered. Boone et al. (2008) point out signs of
interdependence between external auditor rotation and risk margin on allocated
capital contribution in 12,493 surveys on the US capital market during the business
years of 19742001. Capital costs decrease in the first years of the assignment and
rise with its duration. Finally, based on 12,892 US corporations in the business years
of 19911998, Davis et al. (2009) state that the management takes advantage of its
leeway in decisions and arrangements in short (23 years) and very long duration of
assignment (at least 13 years) in order to fulfill or outdo result prognoses. The latter
is considered positive by the capital market and may reflect in a higher demand of
shares. So, the duration of the audit assignment has a positive effect on the extent of
maximum earnings management, so that audit quality is increased by external
rotation after a longer duration.

3.2.2 Decrease or lack of proof of increase

Recent studies mainly do not document a tendency of weakening the quality of

accounting and auditing due to external rotation. Comparatively short assignments
(23 years) cause higher training costs combined with a lower quality of accounting
(Johnson et al. (2002)) in 11,148 US surveys during the business years of
19861995, while there exists no lower quality in long-term assignments (at least
9 years). Auditors in long-term assignments (more than 5 years) disapprove of a
maximum accounting policy due to learning and experience effects (Myers et al.
(2003)) in 42,302 US corporations between 1988 and 2000. Al-Thuneibat et al.
(2011) state a negative correlation between external rotation and the quality of
accounting in 358 Jordan companies listed at the stock exchange between 2002 and

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2006. In a survey of 35,82638,794 US corporations between 1990 and 2000, Ghosh

and Moon (2005) show that investors, rating agencies and analysts assume positive
interdependence between the duration of assignment and the quality of accounting,
represented by the interest rate investors require, rating results, as well as the
analysts performance prognoses. Contrary to their results with US students on
internal rotation, Gates et al. (2007) show that investors confidence in the financial
accounting quality in a regulatory environment with increased Corporate Gover-
nance methods cannot be influenced by external auditor rotation. Furthermore,
according to Carcello and Nagy (2004) based on the business years of 19902001,
267 US corporations showed balance manipulations mostly in the first 3 years of the
assignment, since the management assumes lower quality of audit provided by new
auditors. A long-term assignment (at least 9 years), however, does not imply a
significant increase of balance manipulations.
Rotation can lead to negative capital market responses in the assessment of stocks
of risk intensive companies (Mansi et al. (2004), based on 8,529 US surveys between
1974 and 1998). Therefore, with greater entrepreneurial risk, investors tend to rate the
auditors learning and experience effects in a long-term audit assignment higher than
possible limitations of his independence. Independence in appearance of the capital
market does not decrease with extended assignments (Knechel and Vanstraelen
(2007), based on 618 Belgian companies for the business years of 19921996).
Azizkhani et al. (2007) see the duration of assignment in 2,033 Australian companies
between 1995 and 2005 which are audited by Non-Big-Four audit firms in an inverse
relation to the size of capital costs, whereas there are no significant changes under
external rotation. Fargher et al. (2008) compare the impact of internal and external
rotation on 590 Australian companies during the business years of 19902004. In the
first years after an auditor change (internal rotation) the management lowers the extent
of accounting policy. Under external rotation, however, a significant increase of
discretionary periodical classification is established.
Furthermore, the probability of restrictions in going concern opinions are lower
in the first years of the assignment based on a higher reporting error rate of the
auditor (Geiger and Raghunandan (2002), based on 117 US Corporations with
significant liquidity issues between 1996 and 1998; Jackson et al. (2008) based on
1,750 companies in the Australian capital market between 1995 and 2003).
Interdependences between the duration of assignment and the quality of financial
accounting cannot be established, so that the necessity of external rotation is
ultimately dismissed (Jackson et al. 2008). In the case of the Spanish audit market,
based on 1,326 companies with significant liquidity issues in the business years of
19912000, Ruiz-Barbadillo et al. (2009) are not able to prove empirically that an
external auditor change increases the probability of restricted going concern
opinions.

4 Summary

The external auditor must be independent from management in order to ensure

appropriate financial accounting and audit quality. This basic requirement includes

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independence in fact and independence in appearance (by the investors). Based on

the principal agent theory, auditor independence reduces the probability of his
collaborating with management against the companys target groups by having his
impartiality compromised, thus filing unfounded reports. Internal and external
rotation of the auditor might strengthen his independence. While in the 8th EC
directive only internal rotation is mandatory, the EC regulation draft of 2011
contains a mandatory external rotation after 6 years. The link between rotation rules
and accounting respectively audit quality is controversial because the EC does not
provide a theoretically or empirically founded economic justification for the reform
measures. Insofar, the aim of the analysis was to evaluate the principal agency
theory and recent results of empirical audit research. Increased auditor indepen-
dence will not necessarily be reached by rotation rules due to lower learning and
experience effects. The total effect of rotation on accounting and audit quality can
be negative even under low balling and an increased expectation gap. Empirical
studies, summarized in Table 2 and sorted by internal and external rotation, show
that accounting and audit quality might not increase under external rotation rules. In
the area of internal rotation, however, there are just as little empirical findings.
Therefore, the extent to which the rotation period of 7 years and the cooling off
period of 2 years as mentioned in the 8th EC directive in the context of internal
rotation an increased quality of accounting and auditing cannot be determined.
Finally, there are some research limitations. The empirical auditor change
research is dominant on the US, Asian and Australian capital market. Only few
studies dwell on EU member states (Italy, Germany, Belgium, and Spain). Then, the
proxies for estimating accounting and audit quality (e.g. discretionary accruals,
restriction of going concern opinions) have a limited value (Velte 2012; Quick
2012). Insofar the EC is requested to perform cross-national empirical studies before
starting a huge intervention on the European audit market by mandatory audit firm
rotation.
In addition, by the majority the potential introduction of an external rotation is
viewed critically in literature (e.g. Stefaniak et al. 2009). This applies to the
European regulatory process particularly. Accordingly, the legal committee of the
European Parliament (EP 2012) provided a statement on the regulation draft of
the EU commission. This statement intends to weaken the significance of some of
the reform measures regarding the annual audit. For example, the change period
with regard to external rotation is to be extended from 6 to 25 years. Yet, it has to be
taken into account that an extension of the change period also might be counted
backwards, hence leading to an immediate change of the auditing company. An
increase in incentives with regard to the voluntary preparation of joint audits by an
extension of the change period is not desirable. Moreover, the minimum duration of
2 years for the first mandate, and hence the periods-overlapping auditing contract is
highly controversial. It is rather suggested to stipulate the yearly re-appointment of
the auditor by the shareholders meeting along the lines of German corporation law.
Likewise, the legal committee argues moderately with regard to the separation of
audit and advisory activities in comparison to the restrictive suggestions of the EC.
Advisory services, especially tax consultancies are still accepted as long as they do
not interfere with the self-review prohibition in addition to the annual auditing.

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Table 2 The link between in-/external rotation and the quality of financial accounting and audit
Author(s) State, business Influencing factors Significant link to the
(Year of publication) year and sample quality of financial
accounting/audit

Internal rotation (=auditor rotation)

Hamilton (2005) Australia Financial accounting (?)
19982003 (discretional accruals)
3,621
Carey and Simnett (2006) Australia Financial accounting ()
1995 (discretional accruals) (?)
1,021 Audit
(going concern opinions)
Azizkhani et al. (2007) Australia Market reactions (Big ()
19952005 Four-audit firms)
2,033 (capital costs of equity)
Blouin et al. (2007) US Financial accounting ()
20012002 (discretional accruals)
407
Gates et al. (2007) US Financial accounting (?)
Experimental (regime with increased
study by corporate
students governance means)
Gul et al. (2007) US Audit (-)
20002001 (non audit fees)
4,.720
Cameran et al. (2008) Italy Financial accounting ()
19852004 (discretional accruals)
1,439
Dao et al. (2008) US Audit (?)
2006 (going concern opinions)
635
Watrin et al. (2008) Germany Financial accounting (-) change of the
20042007 (discretional accruals) authorized auditor
DAX, MDAX, () change of the
SDAX and leading audit
TecDAX partner
companies
Zimmermann (2008) Germany Financial accounting ()
2005 (discretional accruals) (?)
102 Audit (audit fees)
Chi et al. (2009) Taiwan 2004 Financial accounting (?)
(discretional accruals)

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Table 2 continued

Author(s) State, business Influencing factors Significant link to the

(Year of publication) year and sample quality of financial
accounting/audit

External rotation (= audit firm rotation)

Dopuch et al. (2001) US experiment Audit (faulty external (?)
reporting)
Geiger and Raghunandan (2002) US Audit (going concern (-)
19961998 opinions)
117
Johnson et al. (2002) US Financial accounting (-)
19861995 (discretional accruals)
11,148
Myers et al. (2003) US Financial accounting (-)
19882000 (discretional accruals)
42,302
Carcello and Nagy (2004) US Financial Accounting (-)
19902001 (Management Fraud)
267
Mansi et al. (2004) US Market reactions (equity (-)
19741998 costs of capital)
8,529
Ghosh and Moon (2005) US Financial Accounting (-)
19902000 (investor rents, rating
results, earnings
35,826/38,794 forecasts)
Azizkhani et al. (2007) Australia Market reactions (Non- ()
19952005 Big-Four-audit firms)
(equity costs of capital)
2,033
Gates et al. (2007) US Financial Accounting ()
experiment by (regime with increased
students Corporate Governance-
means)
Knechel and Vanstraelen (2007) Belgium Audit (going concern ()
19921996 opinions)
618
Boone et al. (2008) US Market reactions (equity (?)
19742001 costs of capital)
12,493
Fargher et al. (2008) Australia Financial accounting (-) external rotation
19902004 (discretional accruals) (?) internal rotation
590
Jackson et al. (2008) Australia Financial accounting ()
19952003 (discretional accruals) (-)
1,750 Audit (going concern
opinions)

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Table 2 continued

Author(s) State, business Influencing factors Significant link to the

(Year of publication) year and sample quality of financial
accounting/audit

Davis et al. (2009) US Financial Accounting (?)

19911998 (quality of earnings
forecasts)
12,.892
Ruiz-Barbadillo et al. (2009) Spain Audit (going concern ()
19912000 opinions)
1,326
Al-Thuneibat et al. (2011) Jordan Financial accounting (-)
20022006 (discretional accruals)
358

Also, the suggestion of the EC for a general separation of audit and non-audit
services for audit companies exceeding a certain threshold (pure audit firms)
most likely will not be approved by the legal committee. Taken together, the
occasionally non-acceptance of a combined audit and non-audit activity, interfering
with the self-review prohibition, surely is more feasible. This is also supported by
the heterogeneous results of the empirical audit research. It becomes apparent that
the planned reform measures of the EC regulation draft to strengthen auditor
independence fall short and are being modified by the legislation. Yet, the EU
commission should carefully balance the interference with the European audit
market while observing the principle of proportionality. Hence, the risk of the
information theory persists that the auditor only uses information verifiable by the
investors to judge on the audit, if the question of independence is regulated too
much. This form of defensive audit may lead to misjudgements as a result of
insufficient information interpretation, thus affecting the audits evaluation
negatively.

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