Audit Partner Rotation, Earnings Quality and Earnings Conservatism

Abstract

We provide evidence of an association between audit partner rotation and the quality of earnings. It is a requirement for Australian firms that the engagement partner be identified by name in the annual report. Using a sample of 3,621 firm-years between 1998 and 2003, we show that audit partner changes most likely reflecting partner rotation (i.e., they are not due to a switch of audit firm) are associated with lower signed unexpected accruals, and that for Big 5 clients this relation is driven by smaller positive unexpected accruals following partner changes. This result is consistent with more conservative reporting following a rotation of audit partner, and this interpretation is further supported by evidence suggesting a significant increase in the asymmetrically timely recognition of economic losses when firms have a change of audit partner. Our tests also show that these effects occur predominantly among clients of Big 5 audit firms, and that any effect is concentrated in the latter part of our sample period, when partner rotation was a professional requirement. We therefore conclude that audit partner rotation is associated with incrementally greater conservatism in financial reporting, but only in circumstances where the ability of client firms to resist partner rotation is reduced by mandatory partner rotation requirements.

Keywords: Partner rotation, auditor independence, earnings quality, audit quality

JEL Classification: M41, M44, M49, G34, G38