Mandatory Audit Firm Rotation and Big4 Effect on Audit Quality: Evidence from South Korea

Abstract

In South Korea, due to concurrent financial scandals, Korean legislators implemented two major audit policies in the 2000s; the mandatory audit "partner" rotation policy in 2000 and the mandatory audit "firm" rotation policy in 2006. The mandatory audit "firm" rotation policy was introduced as a mean to improve audit quality based on the auditor entrenchment hypothesis. In this paper, we compare the audit quality of firms subjected to mandatory audit "firm" rotation with two benchmark groups, a sample that adopted the policy voluntarily; the second group consists of the mandatory "firm" rotation sample in years prior, a period firms were subject to mandatory audit "partner" rotation. Using accrual-based measures as proxies for audit quality, we find evidence that audit quality of the mandatory rotation firm sample is lower compared to firms that voluntarily adopted the policy. Furthermore, we find evidence that audit quality of the mandatory rotation firm sample is lower compared to the mandatory audit partner firm sample. Additionally, we also find evidence that the mandatory audit firms rotation sample whose auditors were rotated from Non-Big4 to Big4 are generally associated with lower levels of abnormal accruals consistent with the argument that the audit quality of Big4 accounting firms is superior to Non-Big4 firms. Finally, longer audit tenure and switches to Big4 audit firms generally have a positive effect upon audit quality. These findings suggest that extended audit tenure improves audit quality due to accounting firm’s accumulated client specific knowledge. Thus, our evidence suggests that the mandatory audit firm rotation policy did not have the desired effect in a Korean context.