INFORMATION TO USERS This manuscript has been reproduced from the microfilm master. UMI films the text directly from the original or copy submitted. Thus, some thesis and dissertation copies are in typewriter face, while others may be from any type of computer printer. The quality of this reproduction is dependent upon the quality of the copy submitted. Broken or indistinct print, colored or poor quality illustrations and photographs, print bleedthrough, substandard margins, and improper alignment can adversely affect reproduction. In the unlikely event that the author did not send UMI a complete manuscript and there are missing pages, these will be noted. Also, if unauthorized copyright material had to be removed, a note will indicate the deletion. Oversize materials (e.g., maps, drawings, charts) are reproduced by sectioning the original, beginning at the upper left-hand comer and continuing from left to right in equal sections with small overlaps. Each original is also photographed in one exposure and is included in reduced form at the back of the book. Photographs included in the original manuscript have been reproduced xerographically in this copy. Higher quality 6” x 9” black and white photographic prints are available for any photographs or illustrations appearing in this copy for an additional charge. Contact UMI directly to order. UMI A Bell & Howell Information Company 300 North Zeeb Road, Ann Arbor MI 48106-1346 USA 313/761-4700 800/521-0600 R ep ro d uced with perm ission o f th e copyright owner. Further reproduction prohibited without perm ission . Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. NORTHWESTERN UNIVERSITY Auditor Rotation and Retention Rules: A Theoretical Analysis A DISSERTATION SUBMITTED TO THE GRADUATE SCHOOL IN PARTIAL FULFILLMENT OF THE REQUIREMENTS for the degree DOCTOR OF PHILOSOPHY Field of Accounting and Information Systems By Eric C. Weber EVANSTON, ILLINOIS June 1998 R ep ro d uced with perm issio n of the copyright ow ner. Further reproduction prohibited withou t perm issio n . DM! Number: 9832711 Copyright 1998 by Weber, Eric C. Ail rights reserved. UMI Microform 9832711 Copyright 1998, by UMI Company. All rights reserved. This microform edition is protected against unauthorized copying under T itle 17, United States Code. UMI 300 North Zeeb Road Ann Arbor, MI 48103 R ep rod u ce d with p erm ission of the copyright ow ner. Further reproduction prohibited without perm ission. © Copyright by Eric C. Weber 1998 All Rights Reserved ii R ep rod u ced with perm ission o f th e copyright ow ner. Further reproduction prohibited without perm ission. ABSTRACT Auditor Rotation and Retention Rules: A Theoretical Analysis Eric C. Weber Adviser: Professor Ronald A. Dye This dissertation examines the consequences of restricting firms’ freedom in replacing their auditors. While U.S based firms can replace their auditors whenever they choose to do so, subject to their shareholders’ approval, many western European countries impose limitations on auditor replacement, and critics o f the audit profession have proposed similar restrictions on U.S based firms. These restrictions take the form o f either mandatory rotation or mandatory retention of an auditor for designated time intervals. Proponents o f the rules claim that such rules will increase audit quality, while opponents of the rules assert that the rules will decrease audit quality and increase audit costs. The analytical models in this dissertation address how such rules affect the quality and price of audit services. The dissertation demonstrates that the relative performance o f audit markets with these rules in place relative to laissez faire depends upon whether audit clients can, in the laissez faire regime, credibly threaten to replace their auditor iii R ep rod u ced with perm ission o f th e copyright ow ner. Further reproduction prohibited without perm ission. when the auditor proposes to release an unfavorable audit report. The dissertation demonstrates circumstances under which, when such threats are credible, switching to either a mandatory rotation or mandatory retention regime results in some improvements. In some cases, the dissertation demonstrates that audits o f fixed duration (which entail both mandatory retention and mandatory rotation) can maximize audit quality, albeit at a potential increase in audit switching costs. However, economic settings in which audits o f regulated duration uniformly improve the performance of the audit function are demonstrated to be quite limited, since voluntary resignations and/or replacements of auditors are themselves informative about a client firm’s financial condition. Required rotation, or required retention, of an auditor may result in the suppression of this source o f information about a client. iv R ep ro d uced with perm issio n of the copyright ow ner. Further reproduction prohibited without perm issio n . ACKNOWLEDGEMENTS I would like to thank the members of my dissertation committee for their support and guidance throughout the entire process o f this work: Ronald A. Dye (chairman), Larry Jones, Robert P. Magee, and Sri Sridharan. I also thank my fellow doctoral students at Northwestern University, with whom I have spent not only many hours of work, but also unforgettable moments o f friendship. Finally, I would like to dedicate this dissertation to my family: Maria, Yvonne, Irene, Rafael, and Ana Maria. Thank you for your support and never-ending patience. v R ep rod u ced with perm ission o f th e copyright ow ner. Further reproduction prohibited without perm ission. Table o f Contents 1 Introduction 1 2 Mandatory Rotation/Retention Rules and Audit Quality 14 2.1 Model Description 14 2.1.1 Use and Consequences o f the Auditor’s Report 18 2.2 Infinite Horizon Model without Retention/Rotation Regulation 20 2.2.1 Model without Credible Threat to Replace Auditors that Report Fraud 20 2.2.2 Model with a Credible Threat to Replace Auditors that Report Fraud 24 2.2.3 Conditions under which the Replacement Threat is Credible 27 2.2.4 Government Preference Ordering 30 2.3 Infinite Horizon Model with Retention/Rotation Regulation 3 5 2.3.1 Two-Period Mandatory Retention Case 36 2.3.2 Two-Period Mandatory Rotation Case 41 2.3.3 Two-Period Mandatory Retention and Rotation 45 2.4 Summary and Discussion of Chapter 2 48 vi R ep rod u ced with perm ission o f th e copyright ow ner. Further reproduction prohibited without perm ission. 3 Client Opinion Shopping, Auditor Resignation and the Efficiency of Rotation / Retention Rules 51 3.1 Model Description 5 1 3.1.1 Characterization o f Client Firms 51 3.1.2 Characterization o f Auditors 55 3.1.3 Characterization o f the Audit Technology 60 3.1.4 Characterization o f the Go vermnent 63 3.1.5 Second Period Events 69 3.2 Case I: Fraud is Detected in Period One 74 3.2.1 Second Period Client Programs for Case 1 77 3.2.2 Successor Auditor Second-period Bid 80 3.2.3 Incumbent’s Response 83 3.2.4 Client Opinion Shopping versus Incumbent Resignation 92 3.3 Case II: No Fraud is Detected in Period One 102 3.3.1 Auditor’s Beliefs Regarding Fraudulent Clients in Period Two 103 3.3.2 Second Period Client Programs for Case II 106 3.3.3 Successor Auditor Second-period Bid 108 3.3.4 Incumbent’s Response 108 3.3.5 Client Opinion Shopping vs. Incumbent Resignation in Case II 125 3.3.6 Client Opinion Shopping versus Incumbent Resignation: Comparison across Cases 131 vii R ep rod u ced with perm ission o f the copyright ow ner. 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[...]... regimes, standards, and wealth constraints affect auditor behavior,6 and how auditors and their clients respond to report-contingent audit contracts,7 but little research exists regarding mandatory rotation and mandatory retention rules Arrunada and Paz-Ares [1997], analyze the effect o f mandatory auditor rotation on audit cost and quality They show that mandatory auditor rotation increases audit cost and. .. auditor- initiated and client-initiated auditor switches are feasible In scenario three, auditor switches are observed only after a qualified audit opinion Here again, both auditor- initiated and client-initiated auditor switches are feasible In scenario four, auditor switches can be observed both after a clean and a qualified audit opinion, and be caused by both a client-initiated auditor switch or a client-initiated... client-initiated auditor switch After completing the analysis of the deregulated audit market, mandatory rotation and mandatory retention rules are introduced I show that no unconditional (not scenario dependent) mandatory auditor rotation or mandatory auditor retention rules exists that increases the expected probability o f fraud detection (i.e., increases audit quality) when compared to the deregulated market... auditor- initiated auditor switches I further explore the effects that mandatory auditor rotation rules and mandatory auditor retention rules have on audit quality, and the impact of these rules on the fee that client firms pay for the audit function The “benchmark” case against which these mandatory rules are compared, in both setups, is given by a “deregulated” audit market where no restrictions are placed... specific assets and the distortion of competition, but their results of the effect on audit quality are inconclusive, even though they hypothesize that a negative impact on audit quality is a highly plausible effect Gietzmann and Sen [1997], analyze the role of mandatory auditor rotation in a setting where a trade-off between auditor reputation and reappointment exists They argue that mandatory rotation. .. clear from the above discussion that issues surrounding the regulation of the auditing profession, be it through self-regulation or through mandatory regulation, are far from solved, and that proposals such as mandatory rotation or mandatory retention of independent auditors are still major concerns of regulatory bodies in many countries Previous research has addressed how changes in liability and liability... that they will report fraud if fraud is detected Contrary to the setup of Chapter 2, client-initiated auditor switches are not exogenously imposed That is, a credible termination threat may not always exist for the incumbent auditor who detects fraud in period one However, comparisons between an audit market where mandatory rotation or mandatory retention rules are imposed and a deregulated audit market... mandatory auditor retention rules have on the audit function Proponents o f this form of audit regulation claim that under such rules audit quality will increase, while the detractors sustain that audit quality will decrease, and that audit costs will increase In Chapter 2 , 1 first analyze how different auditor rotation and retention regimes affect the quality of audit services when all auditors are homogeneous... rales have systematically been rejected by the auditing profession The commonly-asserted disadvantages of mandatory auditor rotation or retention relate either to an increased audit cost or the risk of a decline in audit quality Glynn and Ridyard [1992], argue that periodic compulsory rotation of auditors causes potentially high disruption costs and raises questions as to the quality of the audit scrutiny... mandatory rotation of auditors every seven years (Petty and Cuganesan [1996]) The Cadbury Report on corporate governance has revived the debate concerning mandatory rotation of auditors contained in the European Commission’s Fifth Directive (Paleson [1993]).1 In Italy, Corporations Law requires auditor appointments to be reviewed after three years with compulsory rotation after nine Spain enacted a similar . regarding mandatory rotation and mandatory retention rules. Arrunada and Paz-Ares [1997], analyze the effect of mandatory auditor rotation on audit cost and quality. They show that mandatory. effects that mandatory auditor rotation rules and mandatory auditor retention rules have on audit quality, and the impact of these rules on the fee that client firms pay for the audit function. The. dissertation is motivated by the fact that mandatory rotation and/ or mandatory retention of independent auditors has often been proposed, and in some cases enacted, by regulators and professional