Selective mandatory auditor rotation and audit quality: An empirical investigation of auditor designation policy in Korea

This study examines the impact of the limited auditor tenure on earnings, and thus audit, quality by taking advantage of the unique audit regulations that govern the listed firms in Korea. I examine how discretionary accruals, a measure of earnings quality drawn from prior literature, vary around an event that imposed a limit on the length of the auditor-client relationship via the auditor designation requirement for Korean firms likely to manage earnings. I find discretionary accruals of firms likely to be a target for mandatory auditor change decrease after the passage of the AAEA, suggesting that a limit on the length of the auditor-client relationship result in greater incentives for auditors to maintain independence, which effectively restrains firms' opportunistic manipulation of earnings. This study adds to our current understanding of the impact of economic incentives on auditor independence by providing additional evidence that opportunities for auditors to earn client-specific economic rents from repeat engagements can be a potential threat to auditor independence. In addition, this study contributes to the current stream of research on the implications of mandatory audit firm rotation and informs policy makers in the current debate on improving auditor independence. I provide evidence that under an audit regime similar to mandatory auditor rotation, audit quality does appear to improve when the duration of the auditor-client relationship is truncated. This suggests that mandating auditor rotation could enhance auditor independence and provide auditors greater incentives to resist management pressures.