The International Debate Over Mandatory Auditor
Rotation: A Conceptual Research Framework
Anthony H. Catanach Jr.
Paul L. Walker
This paper contributes to the recent international debate over mandatory auditor rotation by
providing a conceptual research framework in which to view the tenure-audit quality relation.
Audit quality is viewed to be a function of auditor performance. The auditor’s ability and
professional conduct are argued to be major factors affecting performance. Economic
incentives and market structure have endogenous relationships with both performance and
tenure. Research implications of the framework suggest that evaluating the efficacy of
mandatory auditor rotation is likely to be a complex process, more involved than a simple
association test of the tenure-audit quality relation. The study also proposes several avenues
for future examination: (1) evaluation of assumptions implicit in rotation arguments; (2)
testing of magnitudes and effect directions; (3) examination of professional oversight con-
trols; and (4) assessment of the costs of compulsory rotation. © 1999 Elsevier Science Inc. All
rights reserved.
Key Words: Mandatory Auditor Rotation; Tenure; Audit Quality
INTRODUCTION
Accountants and academics have debated the need for mandatory audit firm
rotation for decades. Israel, Italy, and Spain are among the few countries that have
adopted mandatory rotation policies. Canada considered the idea for years and
critics of the accounting profession in Australia, Germany, and the United
Kingdom recently proposed rotation as a solution to independence concerns in
those countries. The American Institute of Certified Public Accountants (AICPA)
Anthony H. Catanach Jr. ● Villanova University, College of Commerce & Finance, 800 Lancaster
Avenue, Villanova, PA 19085–1678; Phone: 610–519–4825; Fax 610–519–5204; E-mail:
Paul L. Walker
● University of Virginia, McIntire School of Commerce,
Monroe Hall, Charlottesville, VA 22903–2493.
Journal of International Accounting, Auditing & Taxation, 8(1):43–66 ISSN: 1061-9518
Copyright © 1999 by Elsevier Science Inc. All rights of reproduction in any form reserved.

attempted to dispel criticism of the profession in the United States (U.S.) by
issuing a Statement of Position on Mandatory Audit Firm Rotation in 1992. In
1994, the U.S. Securities and Exchange Commission (SEC) also considered the
issue in its report draft on auditor independence, and the U.S. Senate subsequently
drafted legislation requiring auditor rotation for all telecommunication compa-
nies.
1
The recent formation of the Independence Standards Board also supports a
need for analysis of regulatory actions that promote auditor independence.
2
Despite continued professional debate, little research exists to support either the
adoption or rejection of mandatory rotation.
This paper reviews the compulsory rotation issues raised internationally,
summarizes the existing research evidence on this controversial topic, and
proposes a conceptual framework to guide future examinations of the tenure-
audit quality relation. By identifying and organizing the major constructs
associated with the rotation issue, this framework provides a foundation for
the future development of more formalized logical or mathematical models
to yield testable research hypotheses. The proposed framework suggests that
endogeneity among many of the constructs adds complexity to the tenure-
audit quality relation, particularly when national and cultural differences are
considered.
THE CONTROVERSY SURROUNDING MANDATORY AUDIT ROTATION
Arguments for Compulsory Rotation
Over the years major organizational collapses have been attributed to
poor audit quality associated with a perceived lack of auditor independence.
These alleged “audit failures” were deemed to have occurred because auditors
failed to either detect or report material errors in the financial statements.
Mandatory auditor rotation (compulsory rotation) frequently has been sug-
gested as a means of strengthening independence and reducing the incidence

of audit failure.
3
Proponents of mandatory rotation argue that it will prevent long-term
auditor-client relationships from developing that could impair independence and
objectivity. In fact, several studies suggest that longer auditor tenure leads to audit
quality decline (DeAngelo, 1981b, 189; Deis & Giroux, 1992, 470; O’Keefe et al.,
1994, 53; Raghunathan et al., 1994, 33). Rotation advocates propose that it would
reduce audit failures, force clients to adopt conservative accounting practices, and
result in more complete financial statement disclosures (OCA, 1994, 53). Rotation
also would ensure that a company’s representations, particularly those in subjec-
tive and judgmental areas (e.g., intangibles), would be reviewed by different audit
“experts.” If the tenure period were limited, auditors also would have greater
incentives to resist management pressures (AICPA, 1992, 1–2). Finally, support-
44 INTERNATIONAL ACCOUNTING, AUDITING & TAXATION, 8(1) 1999
ers of rotation suggest that it would foster a more competitive market. However,
to date the evidence is mixed on this issue.
4
Arguments Against Mandatory Rotation
Opponents of compulsory rotation generally acknowledge the potential ben-
efits of its adoption, but argue that implementation costs (both to the auditor and
client) greatly exceed the limited gains perceived (AICPA, 1992, 2). The Cohen
Commission (1978) indicated that duplication of start-up costs, including the time
auditors spend gaining familiarity with the client company, would increase auditor
costs considerably.
5
Lost audit efficiencies also may increase costs. Arrunada and
Paz-Ares assert that predecessor auditors will not be able to transfer their knowl-
edge of the client, its accounting system, and market to successors, and this “value
is destroyed by rotation” (European Accountant, 1995b, 7). Additionally, Euro-
pean professionals note that rotation may reduce auditor incentives to invest in

specific industries (European Accountant, 1995b, 7; Petty & Cuganesan, 1996,
41). If auditors must periodically abandon an industry that requires special
knowledge, they may be less willing to specialize in it.
The accounting profession argues that mandatory rotation denies auditors the
ability to assess the true financial situation of a company because their under-
standing of the client’s business, operations, and systems would be limited to only
a few years (European Accountant, 1995a, 4). This view is supported by a recent
AICPA study that found audit failures occurring more frequently when auditors
were performing their first or second audit of a company (AICPA, 1992).
6
Clients also may face increased costs if compulsory auditor change is
required. Management faces the potentially disruptive, time-consuming, and
expensive process of selecting new auditors, and familiarizing them with the
organization’s operations, procedures, systems, and industry (AICPA, 1992, 3).
Increased auditor costs also might lead to reduced competition and higher client
audit fees (European Accountant, 1995b, 7). However, according to the Cohen
Commission, mandatory rotation also could result in “excessive competition”
because clients would have difficulty evaluating audit quality differences across
firms. This heightened competition might lower audit prices and create pressures
that increase the likelihood of faulty audit work. In addition, clients might be
forced to accept a lower quality of service from an auditor who is a generalist, if
fewer auditors invest in specialized industries (Petty & Cuganesan, 1996, 41).
Finally, accounting professionals believe that several key factors in the
auditing industry make mandatory rotation unnecessary. The AICPA (1992, 5)
suggests that auditors are motivated to maintain objectivity and independence by
their desire to protect their reputation and client revenues. Professional behavior
is further assured by quality control standards (e.g., peer review programs and
periodic partner rotation) implemented by accounting and auditing organizations
internationally. Accounting organizations also note that external market forces
(e.g., litigation costs and negative publicity) provide controls on auditor behavior.

45The International Debate Over Mandatory Auditor Rotation
THE INTERNATIONAL DEBATE AND EXPERIENCE
Countries with Active Compulsory Rotation Discussions
While most professional accounting organizations have been reluctant to
accept compulsory rotation, active debates on the issue continue in at least
four countries: Australia, Germany, the United Kingdom (U.K.), and the
United States.
7
Research into recent audit failures in Australia finds a lack of
independence as a major contributing factor (Walker, 1991, 82). Responding
to problem audits witnessed during the 1980’s, the Ministerial Council for
Corporations appointed a working party in 1993 to review auditor regulation.
While fixed appointment terms were recognized to have some merit, the
accounting profession did not support auditor rotation.
8
Not surprisingly, the
working party recommended that “the law not impose fixed terms of appoint-
ment for auditors or otherwise mandate the rotation of auditors” (Common-
wealth Government, 1996, 87).
The auditor rotation question is not new to Germany, but the current debate
marks the first time that the issue has been discussed so widely. The near collapse
of the Metallgesellschaft group in 1994 due to dubious oil derivatives contracts
has renewed interest in the topic. In the past few years, the president of the
German Shareholders’ Association has called for the mandatory rotation of
auditors every five years (Corporate Accounting International, 1994; European
Accountant, 1995a, 4). As in many countries, the German accounting profession
is universally opposed to rotation. However, Germany’s central bank, the Bundes-
bank, recently introduced auditor rotation to encourage German companies to
consider the idea (European Accountant, 1996b, 4).
9

During the 1980’s several high profile episodes occurred in the U.K. that
suggested deficient auditing practices: DeLorean, Johnson Matthey, Milbury,
Westminster Property, Lloyd’s, and Alexander Howden. In response, the
government proposed reforms (the EC Eighth Directive) that would curtail
non-audit services by auditors and require rotation. However, lobbying by the
accounting profession and its corporate clients succeeded in postponing gov-
ernmental intervention. Auditing practices again came under scrutiny in the
early 1990’s in such cases as Polly Peck, Maxwell, BCCI, and Levitt.
10
This
time, the profession commissioned two investigations (the Cadbury Commit-
tee and the McFarlane Report) to investigate the role of auditing in these
scandals and the need for self-regulation. While the Cadbury Committee
opposed the rotation of auditors, the McFarlane report suggested that auditors
be appointed for a fixed five year term.
During the last twenty years, the U.S. Congress has held extensive hearings
on the public responsibilities of the accounting profession and its ability to
regulate itself (Leibman & Kelly, 1992, 362). During the 1970’s, outside auditors
failed to detect criminal activity among several large U.S. corporations. As a
46 INTERNATIONAL ACCOUNTING, AUDITING & TAXATION, 8(1) 1999
result, the Moss-Metcalf inquiries examined the profession’s ability to detect
management fraud and its effectiveness in disclosing bribes to foreign officials
(Previts & Merino, 1979, 318). The Metcalf Committee staff report concluded that
insufficient independence between auditors and their clients may have contributed
to these conditions, and suggested rotation as a solution to the auditor indepen-
dence problem.
11
However, in 1978 the Cohen Commission, an independent
commission established by the AICPA, concluded that rotation should not be
required because its potential benefits would be offset by associated costs (Cohen

Commission, 1978, 108).
Audit failures stemming from the bank and thrift crises of the 1980’s
reignited discussion of the effectiveness of the U.S. accounting profession’s
self-regulation program. The Dingell Committee specifically investigated the
potential conflict of interest inherent in the auditor-client relationship. The ac-
counting profession responded by implementing several organizational changes to
promote self-regulation including the adoption of a peer review program. Nev-
ertheless, critics of the profession continued to call for mandatory auditor rotation,
standardization of fees, and other constraints on the auditor-client relationship
(Chatov, 1985, 173). In 1991, the U.S. Comptroller General discussed with Big
Six audit firms the possibility of requiring banks to change their auditors on a
periodic basis (World Accounting Report, 1991, 257). In 1993, Walter Schuetze,
then Chief Accountant of the SEC, proposed mandatory auditor rotation as a
solution to the accounting profession’s inability to self regulate (Craig, 1993, 18).
Despite continued SEC interest in the independence issue, neither the SEC nor the
AICPA, has endorsed the idea of audit firm rotation.
12
International Experience with Mandatory Rotation
Italy currently requires the mandatory rotation of external auditors on listed
companies, insurers, investment houses, newspaper publishers, state-owned busi-
nesses, and companies benefiting from state aid. These companies can keep the
same auditor for a maximum of three, three-year terms (or nine total years). The
Italian securities regulatory agency, Consob, also has the authority to approve the
selection of auditors and to set fees. Consob’s oversight may minimize any excess
competition (e.g., fee cutting) caused by rotation, that could result in fewer audit
procedures and lower audit quality (OCA, 1994, 54). Although continuing cor-
porate scandals in Italy suggest the ineffectiveness of compulsory rotation, its
“true” effects remain unknown.
13
Israel adopted audit rotation on “government companies” in the early 1970’s

in response to calls by smaller accounting firms for more work. While these firms
are required to change auditors every three years, the requirement appears to be
loosely enforced. Recently, management of the Electricity Corporation, one of the
largest and most profitable companies in Israel, successfully postponed a change
in auditors indefinitely (World Accounting Report, 1996, 20).
47The International Debate Over Mandatory Auditor Rotation
Prior to 1996, the Spanish government required companies to change audi-
tors every three, six or nine years with the total tenure period limited to a
maximum of nine years (European Accountant, 1995b, 7). Unlike other countries,
Spain apparently did not adopt rotation in response to concerns over auditor
independence. Instead, rotation was implemented to allow local firms to gain
market share (European Accountant, 1996a, 9). Spain recently has abandoned
mandatory rotation and some have considered its decision to be evidence that
rotation is not needed elsewhere.
14
In summary, auditor rotation generally appears motivated by public concerns
over large, high-profile corporate collapses. As companies fail, auditors are
criticized for their performance and perceived lack of independence, and calls
originate for regulation of the accounting profession. As evidenced in Spain,
mandatory rotation also may increase competition in the audit market.
DEVELOPMENT OF A FRAMEWORK
Despite the historical controversy over compulsory rotation, little analytical or
empirical research exists to either support or reject its adoption.
15
In fact, the AICPA
(1992, 2) states “there is no empirical evidence to support the perceived benefit of
mandatory audit firm rotation.” Moreover, the potential impact of national and
cultural differences on mandatory rotation also has been ignored. Proponents of
rotation argue that long-term client relationships lead to lower audit quality and,
ultimately, audit failure. To support their position, they point to empirical studies of

the tenure-audit quality connection. To date, the preponderance of empirical evidence
reveals a negative association between tenure and audit quality. Using audit engage-
ment hours as a proxy for audit quality, Palmrose (1989, 496) finds that quality
declines with firm tenure. Copley and Doucet (1993, 32) report that the likelihood of
a substandard audit increases with the length of auditor tenure. O’Keefe et al. (1994,
52) show initial engagements to be associated with fewer violations of generally
accepted accounting standards than repeat engagements. Raghunathan et al. (1994,
33) reveal that audit failures are more likely to occur in the first year or after the fifth
year, further suggesting a tenure-audit quality relation. In their examination of law-
suits filed against auditors, St. Pierre and Anderson (1984, 249) reveal that only 23
percent are associated with audit-client relationships of three years or less. Deis and
Giroux (1992, 474) and Giroux et al. (1995, 76) also indicate that audit quality
declines with the length of auditor tenure.
These investigations generally have assumed simple associations between
tenure and professional conduct (usually independence), as well as between
professional conduct and audit quality. Consequently, a simple causal relation
between auditor tenure and audit failure is implied. However, rotation supporters
acknowledge that audit failures may be associated with factors other than tenure,
suggesting that the link between longer terms and audit quality is not likely so
simple or direct. A framework that accumulates and integrates the various
48 INTERNATIONAL ACCOUNTING, AUDITING & TAXATION, 8(1) 1999
elements associated with the tenure-audit quality issue likely will assist both
researchers and accounting professionals in addressing the compulsory rotation
question. Moreover, such a structure represents a necessary first step towards
future model development and empirical investigation. The framework outlined in
this paper synthesizes the relevant audit tenure and quality literature and considers
anecdotal arguments both in favor of and against rotation. In doing so, it
specifically incorporates both micro and macro economic influences relevant to
the debate. Framework development begins with a general discussion of audit
quality and its determinants. Next, the potential associations among audit quality,

performance, and tenure are discussed. The paper then reviews the possible
endogenous relations of economic incentives and market structure with perfor-
mance and tenure. A summary of the proposed framework’s major constructs and
related professional factors is presented in Table 1.
Determinants of Audit Quality
Proponents of compulsory rotation view it as a means to reduce the likeli-
hood of audit failure. However, audit failure is simply the observed outcome of
TABLE 1
Summary of Constructs and Related Professional Factors
Constructs Professional Factors
Audit Quality
Ability (Detection) Technical competence
Knowledge (training, education)
Experience (professional, industry, client-specific)
Adaptability
Technological proficiency
Professional Conduct (Reporting) Independence
Objectivity
Integrity
Due professional care
Conflicts of interest
Judgement
Economic Incentives General (fees, costs, profits)
Efficiency
Innovation
Management advisory services
Litigation
Market Structure Competition (market share, concentration)
Supply and demand
Entry barriers (economies of scale, product differentiation

and diversification)
Professional regulatory mechanisms
Auditor Tenure Length of audit engagement
49The International Debate Over Mandatory Auditor Rotation
poor audit quality. DeAngelo (1981a, 115) defines audit quality as the probability
that an auditor will both discover and truthfully report material errors, misrepre-
sentations, or omissions in a client’s accounting system. The probability of
discovering (detection) such breaches depends on an auditor’s technical compe-
tence or ability (Deis & Giroux, 1992, 464). Prior studies have suggested that the
probability of reporting is a function of independence (DeAngelo 1981a, 116;
Raghunathan et al., 1994, 35), honesty (Watts & Zimmerman, 1981), and integrity
(Johnson & Lys, 1990, 281). Therefore, this paper views the probability of
reporting errors as dependent on a much broader concept: the auditor’s profes-
sional conduct. This approach allows the framework to encompass such additional
factors as independence, objectivity, due professional care, conflicts of interest,
and judgment, all of which are cited by the U.S. accounting profession as critical
to ensuring the public trust (AICPA, 1991, 4–12).
DeAngelo (1981a, 116) indicates that the probabilities associated with de-
tection and reporting are unlikely to be separable. Deis and Giroux (1992, 464)
note that prior audit quality studies generally assume auditor competence, and
focus on only one professional conduct factor: independence.
16
However, they
acknowledge that without information about the auditor’s technical capabilities,
the complex set of interrelationships between auditor performance and audit
quality cannot be fully understood. Previts (1985, 155) confirms that indepen-
dence, skill and legality, professionalism, and adaptability play major roles in the
attest function. Therefore, this paper depicts audit quality as a function of two
broad performance constructs: ability and professional conduct.
Yardley et al. (1992, 153) indicate that the audit firm’s performance is a

function of economic considerations (fees, costs, profits), efficiency, and innova-
tion. Raghunathan et al. (1994, 37–38) argue that economic incentives may
influence both detection and reporting. They propose that large, fee-paying clients
are likely to be more difficult to audit, resulting in an increased likelihood of a
failure to detect financial statement errors, despite adherence to professional
conduct standards. They also suggest that the possibility of being terminated by
a client could affect an auditor’s reporting decision. Consequently, the proposed
framework includes economic incentives as a factor influencing auditor perfor-
mance, specifically both ability and professional conduct.
Both sides of the rotation debate argue that such a policy will affect
competition. Potential cost increases associated with rotation could increase fees,
lead to price cartels, and reduce competition. Alternatively, restricting auditor
tenure might promote increased fee competition if clients are less able to dis-
criminate between the audit quality of different firms. Proponents point to the
Italian experience as evidence that competition increases with rotation. However,
the Spanish market provides evidence to the contrary. Nevertheless, these expe-
riences suggest that audit market structure must be considered in any attempt to
explain the audit function. Elitzur and Falk (1996a, 260) concur, acknowledging
that supply and demand may play a role in planned audit quality. Additionally,
50 INTERNATIONAL ACCOUNTING, AUDITING & TAXATION, 8(1) 1999
DeAngelo (1981b, 189) relies on competitive pressures to provide auditors with
economic incentives to reduce audit quality. Therefore, the proposed framework
includes a construct to capture market structure influences on both auditor
performance and audit quality.
To summarize, this paper argues that audit quality is a function of two
performance constructs (ability and professional conduct) each of which may be
affected by an auditor’s economic incentives. Market structure also interacts with
both auditor performance and audit quality. The following sections describe the
interrelationships among these factors in the context of the compulsory rotation
issue. Figure 1 depicts the conceptual framework of the tenure-audit quality

relation proposed by this paper.
Performance Determinants
Ability. Since the probability of discovering irregularities in a client’s
system of accounting depends on an auditor’s capabilities, ability must be con-
sidered when examining the compulsory rotation issue. In fact, the first general
standard of U. S. auditing states that “the audit is to be performed by a person or
persons having adequate technical training and proficiency as an auditor” (AICPA,
1972, AU Section 150.02). Deis and Giroux (1992, 464) argue that information
about the technical capabilities of an auditor is critical to distinguishing between
professional conduct (i.e., independence) and ability. This construct is intended to
include such aspects of auditor ability as knowledge (e.g., training, education),
experience (e.g., professional, industry, client-specific), adaptability, and techno-
logical proficiency.
Empirical research results suggest that auditor ability is positively associated
with audit quality (path B3 F, Figure 1). St. Pierre and Anderson (1984, 256)
show that 72 percent of audit litigation cases allege a problem with the auditor’s
interpretation of accounting principles or auditing standards, or allegations of
fraud. The auditor’s ability to address complex accounting issues seems particu-
larly critical to ensuring audit quality. For example, both Stice (1991, 530) and
Feroz et al. (1991, 112) document relationships between companies with complex
financial accounting issues (receivables and inventory) and some type of problem
audit (suits against auditors and SEC enforcement actions, respectively).
17
Opponents of compulsory rotation contend that it will hinder specialization,
thus reducing auditor expertise (European Accountant, 1995b, 7).
18
O’Leary
(1996, 21) indicates that an auditor’s client-specific knowledge grows as the
length of the relationship increases. These arguments suggest a positive relation
between tenure and ability or expertise (path A3 B).

19
Elitzur and Falk (1996b)
also suggest that longer tenure periods motivate the auditor to introduce techno-
logical improvements. Petty and Cuganesan (1996, 41) note that clients may
change auditors if they become dissatisfied with the quality of technical advice
provided during an engagement. This suggests that ability also may be a positive
influence on tenure (path B3 A, Figure 1).
51The International Debate Over Mandatory Auditor Rotation
FIGURE 1. Tenure-Audit Quality Framework. Note: Table 2 provides a detailed description of major path relations presented in the conceptual framework.
Professional Conduct. Professionalism is a key element in any model of
the attest function (Previts, 1985, 155). However, its boundaries are unclear and
defining the construct is troublesome. Previts (1985, 156) suggests the following
characteristics as descriptive of professionalism:
Most important might be a definable body of knowledge, individuality (decisions are personal,
not collective), ethical constraints (self-discipline), altruism (placing the well-being of others
above self-interest), and judgment (decision-making in the face of uncertainty).
Consequently, this construct embraces such attributes as independence, integrity,
objectivity, judgment, and due care.
Proponents of mandatory rotation argue that professional conduct affects
audit quality. Walker (1991, 83) cites auditor gullibility and a willingness to
accept management explanations of questionable transactions without question, as
contributing factors to recent audit failures in the U.K In a survey of U.K. finance
directors, Hussey (1994, 21) finds that the “personal chemistry” between the
auditor and client are important in auditor selection. However, O’Leary (1994, 10)
reveals that close personal relationships between auditors and their clients also
can adversely impact audit quality as in the case of Deloitte, Haskins & Sells and
AWA Ltd., an international trading company. During AWA’s 1986 audit, the
engagement partner became aware of problems in the company’s foreign ex-
change department which he suppressed at the request of his close, personal
friends, the company’s general manager and chief internal auditor.

20
Further
complicating the professional relationship issue is the common practice of ac-
counting firms placing former employees with clients as part of their placement
services (Liebman & Kelly, 1992, 363). These examples appear to support a
positive association between professional conduct and audit quality (path C3 F,
Figure 1).
Feroz et al. (1991, 114) support a connection between professional conduct
and audit quality in an unrestricted tenure environment. They report that almost
twenty percent of the SEC enforcement releases in their study address auditor
independence issues. Stice (1991, 529) also reveals that the likelihood of auditor
litigation (presumably evidence of poor audit quality) is negatively associated
with auditor conduct (i.e., independence).
The behavioral auditing literature suggests that the two performance deter-
minants also are related. Specifically, ability (e.g., technical expertise, experience)
affects judgment quality. Frederick and Libby (1986, 270) demonstrate that the
knowledge base of auditors affects their judgment. Libby and Frederick (1990,
350) find that more experienced auditors exhibit more complete knowledge of
financial statement errors. Anderson et al. (1991, 52) suggest that auditor expe-
riences affect their cognitive representations. Therefore, a positive association
between these two performance factors is shown (path B3 C, Figure 1).
Mautz and Sharaf (1961, 5) and Raghunathan et al. (1994, 40) indicate that
over a long association with a client, the auditor may become less challenged and
less likely to use innovative audit procedures, or may fail to maintain an attitude
53The International Debate Over Mandatory Auditor Rotation
of professional skepticism. This suggests a negative association between tenure
and the professional conduct of an auditor (path A3 C, Figure 1). However,
Magee and Tseng (1990, 315) find that the auditor’s value of incumbency presents
a threat to independence only under limited circumstances. These conditions are:
(1) auditors in the market must disagree among themselves about the appropri-

ateness of the client’s desired reporting policy; and (2) the reporting issue must
affect the client for more than one reporting period. These results suggest that
professional oversight (a component of market structure, discussed below) may
play a mediating role in the relation between tenure and professional conduct.
Economic Incentives
This paper portrays economic incentives as a mediating factor between
tenure and auditor performance. Positive (negative) economic incentives are those
that auditors perceive will increase (decrease) the net cash flows of their firms.
Ability Effects. Raghunathan et al. (1994, 38) note that clients who pay
auditors substantial fees are “likely to be larger and/or more difficult to audit.”
They argue that despite adherence to professional conduct standards, the com-
plexity of these large fee engagements may adversely impact the auditor’s ability
to detect misstatements. Therefore, the positive economic incentives provided by
large fee clients may be negatively associated with auditor ability.
21
Additionally,
auditors frequently expend economic resources (cash outflows) to specialize or
invest in technology to increase their ability (path D3 B, Figure 1). This asso-
ciation is likely negative since auditor economic resources are depleted to increase
ability. Alternatively, Sikka et al. (1993a, 17) propose that technological devel-
opments, as well as the standardization of audit methods, reduce start-up and
learning costs for auditors. Therefore, ability may positively influence economic
incentives as well (path B3 D, Figure 1). Although Yardley et al. (1992, 166)
note no significant association between audit fee and expertise (when market
share proxies for expertise), Craswell et al. (1995, 297) report that specialized
industry auditors in Australia earn fee premiums over non-specialists. This review
of the literature suggests that all audit firms in the market are equally efficient or
inefficient with respect to all clients. However, such an assumption is unlikely to
hold across different countries. Therefore, future researchers may wish to examine
under what circumstances and cultures the framework’s efficiency assumptions

remain valid.
Professional Conduct Effects. The accounting profession has long agreed
that an auditor’s future economic interest in a client may affect that auditor’s
professional conduct. Raghunathan et al. (1994, 36) view the auditor as an
economic agent who makes self-interested decisions. They argue that an auditor
54 INTERNATIONAL ACCOUNTING, AUDITING & TAXATION, 8(1) 1999
may be less willing to report misrepresentations if client revenue losses are
possible. Walker (1991, 83) notes that auditors of public firms are subject to
enormous time and economic pressures that may affect their judgment negatively.
Additionally, management advisory services (MAS) may provide economic in-
centives that adversely affect professional conduct. Sikka et al. (1993b, 13) argue
that when accountants provide non-audit services, they jeopardize independence
by “auditing” the work of their own colleagues as evidenced by the frauds and
collapses in the U.K. of Roadships in 1976 and Burnholme and Forder in 1979.
Therefore, this study connects economic incentives and professional conduct
(path D3 C). Conversely, it is likely that the degree to which professional
conduct is exercised will impact the economics of an audit contract (path C3 D).
It is not clear whether these associations should be positive or negative. If auditors
use greater professional care, presumably this will increase costs and reduce
economic incentives associated with the engagement. However, a higher level of
professional conduct also might minimize the probability of litigation costs
associated with poor audit quality.
DeAngelo (1981b, 189) suggests that incumbent (tenured) auditors cap-
ture client-specific quasi-rents. When faced with competitive pricing pres-
sures, she argues that incumbent auditors can choose to lower audit quality
and price contemporaneously to preserve quasi-rents. Tenure is expected to
increase auditor economic incentives (path A3 D, Figure 1) to conceal
discovered irregularities, resulting in reduced independence, which contrib-
utes to audit quality decline.
22

However, an auditor’s economic incentives also
may influence tenure (path D3 A, Figure 1). In fact, Beck et al. (1988a, 51)
extend DeAngelo (1981a, 113) by including a market for MAS and identifying
conditions under which auditor-auditee bonding is elevated by MAS involve-
ment. Beck et al. (1988b, 65) provide some support for the idea that tenure
increases when recurring MAS are performed for audit clients.
Simulating a mandatory rotation setting, Elitzur and Falk (1996a, 250)
restrict the length of the auditor’s contract and explore the effects of such a
constraint on the auditor’s economic incentives and resulting audit quality. They
measure audit quality by the quantity of audit evidence collected. This paper’s
conceptual framework considers such a measure one of auditor performance
rather than a direct indicator of audit quality (paths A3 D, D3 B). Since Elitzur
and Falk also assume that any errors discovered are corrected, independence
issues are explicitly ignored. They find that higher audit fees motivate auditors to
increase quality, but planned quality depends on the payoffs expected in future
periods. When the engagement period is fixed, the planned level of audit quality
declines over time. They conclude that planned quality is negatively affected by
systematic auditor rotation policies; however, they acknowledge that their anal-
ysis does not consider many other factors such as fee competition and the supply
and demand for audit quality.
55The International Debate Over Mandatory Auditor Rotation
Audit Market Structure
In organizing the existing rotation arguments, this paper’s framework as-
sumes that (1) demand and supply for audits is constant, (2) all firms must be
audited, and (3) audit firms and their clients do not specialize.
23
Yardley et al.
(1992, 152) summarize what is known about audit market structure, its determi-
nants, firm behavior, and performance. According to Yardley et al., a market’s
structure is measured by the size distribution (market share and concentration) of

competing firms, and demand conditions and entry barriers (economies of scale,
product differentiation, diversification). This paper considers professional regu-
latory mechanisms as part of market structure as well. While there is no disagree-
ment that structure is associated with audit firm performance, two competing
views exist as to the direction of causality. The structuralist view holds that supply
and demand conditions determine market structure and that firm behavior and
performance result from market structure. However, another school of thought
assumes that the direction of causation is reversed. Therefore, the market
structure-performance relation is shown in both directions (paths E7B and E7C,
Figure 1) where performance is a function of auditor ability and professional
conduct. This performance specification is consistent with that outlined in Yardley
et al.’s (1992, 153) industrial organization framework.
With respect to professional oversight, Deis and Giroux (1992, 466) indicate
that auditor performance is influenced by certain environmental and behavioral
features: (1) the state of professional ethics; (2) the vigor and visibility of the
profession’s enforcement actions; and (3) the auditor’s interaction with profes-
sional peer groups. They suggest that increased authoritative guidance and vig-
orous review programs to monitor auditor performance are likely to improve audit
quality. Therefore, this study’s framework assumes a consistent enforcement level
and views such professional oversight as a positive influence on both performance
factors (E3 B and E3 C, Figure 1).
As for the tenure-market structure relation, Yardley et al. (1992, 159) suggest
that long industry experience may aid tacit collusion between audit firms if
products are homogeneous and industry conditions are stable. The primary out-
come of such collusion is the ability of leading firms to charge fees in excess of
costs for some clients. However, Arrunada and Paz-Ares argue that when auditors
are stripped of their clients periodically, they may adopt defensive measures (e.g.,
price cartels; European Accountant, 1995b, 7). Furthermore, the Institut der
Wirtschaftsprufer, the auditors’ professional body in Germany, indicates that
rotation may lead to reduced competition because more audits would be concen-

trated in the hands of the bigger firms (Corporate Accounting International,
1994). These arguments suggest that the association between tenure and compe-
tition may be either positive or negative (path A3 E, Figure 1).
Yardley et al.’s (1992, 166) discussion of product differentiation also reveals
possible causal relations between audit quality and market structure, as well as
56 INTERNATIONAL ACCOUNTING, AUDITING & TAXATION, 8(1) 1999
between market structure and auditor tenure. Specifically, they cite DeAngelo’s
(1981b) study which assumes that lower audit quality causes loss of clients.
Therefore, the proposed tenure-audit quality framework includes connections for
both associations. A negative relation is proposed for the audit quality-market
structure linkage (path F3 E) since lower quality is expected to result in a change
of auditors, thus increasing competition.
24
Replacing the auditor also shortens
auditor tenure suggesting a negative association between competition and auditor
tenure (path E3 A, Figure 1). However, according to the AICPA, professional
oversight “helps to assure the objectivity, independence, and professional behav-
ior of public accounting firms” (AICPA, 1992, 4). Therefore, increased oversight
may obviate the need to change auditors suggesting a positive association with
auditor tenure (path E3 A, Figure 1).
RESEARCH IMPLICATIONS
The complexity of the tenure-audit quality framework in Figure 1 may
explain why so few researchers have participated in the international compulsory
rotation debate. With so many potential connections between tenure and audit
quality, it is unlikely that any one study could adequately test the efficacy of a
mandatory rotation policy. In fact, the proposed structure suggests 17 primary
paths. These are summarized in Table 2 together with the direction and a
description of the expected associations and references to the relevant research
literature. Despite this complexity, four avenues of investigation may provide
insight into the mandatory auditor rotation issue: (1) examination of effect of the

framework’s implicit assumptions on proposed associations; (2) tests of magni-
tude and direction effect for the conceptual structure’s path relations; (3) evalu-
ation of controls adopted by the accounting profession to ensure objectivity,
independence, and professional behavior; and (4) assessment of the cost savings
attributed to implementation of professional standard regulations in lieu of man-
datory rotation policies.
Evaluating Framework Assumptions
In capturing both academic and accountant views in the compulsory rotation
debate, the framework incorporates several restrictive assumptions that may
influence the proposed linkages. For example, in discussing the auditor’s eco-
nomic incentives, the structure implicitly assumes equal efficiency for all audit
firms. The framework also presumes no change in the demand or supply of an
audit, and that all firms must be audited. Consequently, researchers may wish to
examine the conditions under which these circumstances can be expected to hold
and how factors such as competition are affected. The impact of national and
cultural differences on the framework’s assumptions also can be evaluated.
57The International Debate Over Mandatory Auditor Rotation
TABLE 2
Primary Path Relation Summary
a
Path
Flows
b
Expected
Associations
c
Supporting Research
d
Description of Proposed Relation
A3B NP None Client-specific knowledge increases with the

length of the client relationship.
A3C Ϫ Raghunathan et al.
(1994)
Professional skepticism and innovativeness of
the auditor declines as tenure increases.
A3D ϩ DeAngelo (1981b),
Elitzur and Falk
(1996a)
Tenured auditors capture client-specific quasi
rents.
A3E NP Yardley et al. (1992) Long industry experience may aid tacit
collusion between audit firms. However,
compulsory rotation may promote
defensive strategies by audit firms (e.g.
price cartels).
B3A NP None Lack of technical expertise or support may
result in an auditor’s termination by a
client.
B3C ϩ Frederick and Libby
(1986), Libby and
Frederick (1990),
Anderson,
Koonce, and
Marchant (1991).
Auditor ability affects judgment.
B3D ϩ Craswell et al. (1995) Technological ability reduces auditor start-up
and learning costs.
B3F ϩ St. Pierre and
Anderson (1984);
Stice (1991); and

Feroz et al. (1991)
Auditor ability positively affects audit quality.
C3D NP None Using greater professional care may increase
engagement costs and/or reduce litigation
costs.
C3F ϩ Stice (1991), Feroz et
al. (1991)
A lack of independence may negatively affect
audit quality.
D3A ϩ Beck, Frecka, and
Solomon
(1988a,b)
MAS involvement increases auditor tenure.
D3B Ϫ Raghunathan et al.
(1994), Elitzur
and Falk (1996a)
Auditor investment and specialization increase
ability. Higher audit fees promote greater
audit effort.
D3C Ϫ DeAngelo (1981b),
Raghunathan et al.
(1994)
Auditor independence may be compromised
by the threat of losing a client’s audit
revenues.
E7B,
E7C
NP Yardley et al. (1992),
Deis and Giroux
(1992)

Direction of causality between market
structure and performance is open to
debate. However, professional oversight is
argued to improve auditor performance.
E3A NP None Competition may reduce tenure and
professional oversight may lower the need
to change auditors.
F3E Ϫ Yardley et al. (1992) Lower audit quality results in auditor
terminations that increase competition.
a
Path flows refer to the linkages illustrated in Figure 1.
b
A ϭ auditor tenure; B ϭ ability; C ϭ professional conduct; D ϭ economic incentives; E ϭ market structure;
and F ϭ audit quality.
c
Relation direction based on cited prior research. NP ϭ no prediction due to competing research results or lack
of theoretical or empirical research.
d
“None” indicates that flows and associations are based on anectodal arguments.
58 INTERNATIONAL ACCOUNTING, AUDITING & TAXATION, 8(1) 1999
Additionally, the resulting structure implies that all auditors have the same
probability for audit failure, as well as for being discovered. Moreover, all
auditors are assumed to have the same expected penalty when an audit failure is
discovered by a third party. Future rotation studies may wish to address the
expected cost of audit failure and its behavior over time.
Investigating Magnitude and Direction of Effect
Researchers also may wish to adopt a multi-step approach to investigate the
mandatory rotation issue. First, previously untested path relations can be exam-
ined for magnitude and direction of effect to determine which performance factors
most strongly impact audit quality. Next, the influence of tenure on performance

and audit quality can be evaluated. If a linkage between tenure and audit quality
is confirmed after consideration of mediating factors, researchers then can eval-
uate the effects of restricting auditor tenure on performance and audit quality.
Proponents of mandatory rotation argue that long-term engagements reduce
auditor objectivity and independence and can ultimately cause audit failure. To
test this assertion, researchers could examine a number of the primary path
relations listed in Table 2 (e.g., A3 B3 F and A3 C3 F). Examination of the
A3 D connection also may provide insight into the accounting profession’s
contention that shortened tenure increases auditor costs. Alternatively, the AICPA
holds that tenure promotes knowledge and improved audit quality. This claim
could be evaluated by testing the A3 B3 F relation. Researchers also may wish
to examine whether restricting tenure increases competition (A3 E), as alleged by
rotation proponents, or if unrestricted tenure reduces audit quality differences
thereby increasing competition (A3 B3 C3 F3 E), as argued by opponents of
rotation. Table 2 suggests that these are just a few of the many possible connec-
tions for which additional research is needed to fully understand the basic
tenure-audit quality relation. These proposed linkages also may help explain what
appear to be inconsistencies in prior tenure-audit quality studies. For example,
performance and market structure factors may help explain Raghunathan et al.’s
(1994, 33) apparently inconsistent findings that an audit failure is more likely to
occur either in the first year or after the fifth year of the engagement.
Evaluating the efficacy of compulsory rotation policies is likely to present a
far greater challenge. The complexity of the proposed structure suggests that a
simultaneous system of equations may more accurately reflect the endogenous
relations of the tenure-audit quality relation than a single linear model specifica-
tion. For empirical examination, such an analysis requires data reflecting tenure,
performance, market structure, and audit quality factors both before and after
implementation of compulsory rotation. Additionally, this information will be
limited to only a handful of countries that have adopted rotation policies. Fur-
thermore, it is unlikely that all of the framework’s connections will be testable

because valid proxies may not be available for many of the constructs (e.g.,
59The International Debate Over Mandatory Auditor Rotation
auditor ability and judgment). Consequently, analytic models and experimental
market studies may play a major role in addressing the effectiveness of compul-
sory rotation.
As previously indicated, several such studies (Elitzur & Falk, 1996a; Magee
& Tseng, 1990) have examined audit quality issues in a fixed engagement period
setting (consistent with compulsory rotation). However, neither permits differen-
tial auditor ability nor do they consider many of the other factors outlined in
Figure 1. These studies can be extended by: (1) evaluating the sensitivity of their
results to specific modeling assumptions; and (2) examining a richer setting that
incorporates more individual and market structure factors. Models that reveal how
mandatory rotation affects auditor performance and the interrelations of its
various components will be particularly valuable in evaluating the arguments of
both sides in the compulsory rotation debate.
Evaluating the Effectiveness of Professional Oversight Controls
The U.S. accounting profession contends that the following measures help to
maintain audit quality: (1) mandatory quality control systems for AICPA member
firms; (2) peer review of the quality control system; (3) required engagement
partner rotation for AICPA SEC Practice Section member firms; (4) second
partner reviews for public company audits; and (5) more stringent auditor respon-
sibilities with respect to the detection and reporting of errors, irregularities, illegal
acts, and internal control weaknesses (AICPA, 1992, 5). These preventive con-
trols appear to acknowledge that reputation, financial incentives (including liti-
gation costs), publicity, and audit committees are insufficient to guarantee auditor
performance and audit quality.
25
However, few studies have examined the effec-
tiveness of these preventive measures in supporting audit quality.
26

The tenure-
audit quality relation and compulsory rotation issue also need to be evaluated in
the context of these market structure controls. For example, how do these
professional controls influence the auditor’s economic incentives and conduct?
Are the effect magnitudes sufficient to overcome tenure concerns (as argued by
opponents to rotation)? Additionally, to what extent do continuing professional
educational (CPE) requirements promote increased auditor ability and increased
audit quality? Does CPE play a role in the rotation debate? Assessing the
contribution of such professional oversight to improved audit quality will provide
additional insight with which to evaluate the need for compulsory rotation.
Assessing Costs of Compulsory Rotation and Its Alternatives
As stressed by its opponents, compulsory rotation is not a costless proposi-
tion. The debate has successfully identified potential sources of increased costs
and the parties that might incur them. However, little attention has been devoted
to quantifying rotation’s benefits or associated costs. Several questions remain
60 INTERNATIONAL ACCOUNTING, AUDITING & TAXATION, 8(1) 1999
that must be answered before mandatory auditor rotation can be considered for
adoption: (1) what will mandatory auditor rotation cost the profession and its
clients; and (2) will the benefits of such policy exceed the estimated costs?
Additionally, neither side of this debate has discussed how compulsory
rotation might affect the existing structure of professional oversight. If rotation
were adopted, would existing requirements (CPE requirements, peer reviews, etc.)
be retained? Or could they be reduced or even eliminated in lieu of rotation? An
analysis of path effect magnitudes in the proposed framework might provide
insight into such questions.
Finally, the AICPA argues that the profession’s costs will increase if rotation
is adopted. However, it is unclear as to whether the increased cost will be shared
uniformly by large, medium, and small auditing firms alike. This may be an
important issue if research shows that mandatory rotation and existing profes-
sional oversight controls are duplicative rather than complementary. Currently,

the AICPA requires all member accounting firms to adopt certain measures to
maintain audit quality (e.g., peer review, partner rotation, second partner review,
etc.). Therefore, all AICPA member firms are incurring costs to maintain audit
quality. If compulsory rotation were to replace exiting oversight measures, would
all accounting firms be affected equally, or would larger firms suffer a larger share
of the cost because they audit larger, more complex, public companies? Such
issues confirm the need to examine the effects on market structure of any costly
proposals intended to enhance audit quality.
SUMMARY AND CONCLUSION
High profile international audit failures during recent decades have reignited
calls for mandatory auditor rotation to improve audit quality. The advantages and
disadvantages of such a policy have been intensely debated for a number of years
by the world’s business community, but little research evidence exists with which
to evaluate rotation’s costs, benefits, and effectiveness. Although several studies
have examined simple associations between auditor tenure and audit quality,
proponents of rotation acknowledge that other factors, not just tenure, contribute
to audit failure. Using prior research and anecdotal arguments common to the
rotation debate, this paper outlines a tenure-audit quality framework to assist both
researchers and professionals in addressing the compulsory rotation issue. Al-
though theoretical support does not exist for many of the arguments asserted in
practice, this framework adds structure to the compulsory rotation debate that may
assist researchers in developing hypotheses in the future.
Audit quality is deemed to be a function of performance. Specifically, the
auditor’s ability and professional conduct are argued to be factors affecting
performance, with economic incentives and market structure playing endogenous
roles in their relations with performance and tenure. The proposed framework
61The International Debate Over Mandatory Auditor Rotation
suggests that evaluating the efficacy of mandatory auditor rotation is likely to be
more complex than examining the association between tenure and audit quality,
particularly when national and cultural differences are considered. The paper

suggests four major avenues for future investigation to evaluate the compulsory
rotation proposal. First, the robustness of the framework’s assumptions must be
evaluated to determine the conditions under which the proposed linkages may
apply. Next, relationships can be examined to determine which performance
factors most strongly influence audit quality, and to what extent tenure affects
performance. The contribution of existing professional oversight measures to
improved audit quality also can be explored to determine whether compulsory
rotation makes an incremental contribution to improved audit quality. Finally,
researchers may wish to examine how compulsory rotation and other costly
proposals intended to enhance audit quality affect audit market structure.
Acknowledgments: The authors acknowledge and appreciate the research
support of the McIntire School of Commerce and Villanova University. We also
are grateful for comments and suggestions received on earlier drafts of this paper
from William Bealing Jr., Joe Gibson, Robert Grinaker, Dana Hermanson, Ron
King, Jagan Krishnan, Susan Perry, Shelley Rhoades-Catanach, James Yardley,
and participants at the 1998 Southeast Regional Meeting of the American Ac-
counting Association.
NOTES
1. The U.S. Senate proposed this legislation (U.S. Senate Bill 1822) to promote auditor
independence, however, it was later dropped in response to intense lobbying by the accounting
profession (AICPA, 1995, 10).
2. In July 1997, the SEC and AICPA announced the formation of the Independence Standards
Board, to create, codify, amend, and preserve independence standards for auditors of public
companies (AICPA, 1997, 14).
3. Mandatory or compulsory rotation refers to an arrangement in which audited organizations are
required to change their auditing firms after some fixed period of tenure.
4. According to Deloitte & Touche’s Italian managing partner, mandatory auditor rotations
contributed significantly to the the firm’s growth rate of 31 percent in Italy during 1994
(European Accountant, 1995c, 11). Managing partner Andrea Ruggeri indicated “we won a lot
of clients under the rotation of auditors,” and he cited the case of Mondadori, a large

publishing company, which under Italian company law was required to change its auditor at
least every nine years. However, Arrunada and Paz-Ares find that rotation results in cost
increases, increased engagement prices, and reduced competition in the Spanish audit market
(European Accountant, 1995b, 7).
5. A KPMG banking partner recently estimated that the combination of rotation and set up costs
would increase audit costs by as much as nine percent each year (O’Leary, 1996, 21).
6. The Quality Control Inquiry Committee of the SEC Practice Section reviewed 406 cases of
alleged audit failure (i.e., lawsuits against auditors) that occurred between 1979 and 1991. It
62 INTERNATIONAL ACCOUNTING, AUDITING & TAXATION, 8(1) 1999
found that audit failure was almost three times more likely to occur during the first two years
of a new engagement (AICPA, 1992, 2).
7. The Norwegian government also has considered auditor rotation and limiting consulting work
for audit clients as possible avenues in regulating the accounting profession (International
Accounting Bulletin, 1994, 8).
8. O’Leary (1996, 22) confirms this attitude in a survey of Australia’s major publicly-listed
companies and largest accounting firm partners. He reports that 87 percent of the corporations
and 93 percent of the auditors oppose compulsory audit rotation. Furthermore, 76 percent of
the companies and 87 percent of the partners do not believe that mandatory audit firm rotation
would improve “actual independence.”
9. The Bundesbank emphasized that its decision to rotate “was by no means a criticism of the
work done by C&L and Wollert-Elmendorff over the past 35 years.”
10. The role of Coopers & Lybrand in the Polly Peck bankruptcy engagement exemplified public
concerns over the impairment of auditor ethics and independence. Polly Peck collapsed in
October 1990 and Coopers together with Touch Ross were appointed joint administrators of
the Company. Prior to its demise, Coopers had served as auditor and financial consultant,
provided tax advice to the Company’s chairman, and recommended the appointment of a
specific finance director.
11. Ralph Nader and the Corporate Accountability Research Group testified before the U.S.
Senate and proposed mandatory rotation of public companies to allow verification of each
audit firm’s work.

12. The AICPA concluded in its Statement of Position Regarding Mandatory Rotation of Audit
Firms for Publicly Held Companies that “audit rotation would not enhance audit quality or
strengthen investor confidence in the objectivity of audits” (AICPA, 1992, 6). The staff of the
SEC concurred with the AICPA’s position and did not recommend legislation “to mandate
rotation of independent accounting firms” in its Staff Report on Auditor Independence (OCA,
1994, 54). However, in his address to the 1996 Annual Meeting of the American Accounting
Association, Michael Sutton, the new Chief Accountant at the SEC, stated that auditor
independence continues to be an issue of great importance to the profession.
13. Early in 1996, Consob revoked Coopers & Lybrand’s audit mandate on Gemina, a financial
holding group, after discovery of unexpected losses. Andersen also was investigated in the
Gemina scandal. Additionally, Andersen had its offices raided by the Italian authorities in a
search for documents relating to its audits of Fininvest, a company owned by a former Italian
prime minister (European Accountant, 1996c, 7).
14. In 1992, the Canadian government also eliminated a compulsory rotation provision in the
Banking Act of 1980 that had required banks to change their auditors every two years (OCA,
1994, 54).
15. To date, only Elitzur and Falk (1996a, 247) have attempted to examine the possible effect of
compulsory rotation on audit quality. However, Magee and Tseng (1990, 316) do examine the
conditions under which auditors compromise independence when binding multiperiod agree-
ments are not possible between clients and auditors and total audit term is finite.
16. Several studies (DeAngelo, 1981a, 116; Goldman & Barlev, 1974, 707; Nichols & Price,
1976, 335) assume that all auditors are technically capable (the probability of discovering an
irregularity is positive and fixed). Elitzur and Falk (1996a, 250) do also, but they assume that
the probability of material error decreases with the quantity of audit evidence gathered.
17. However, in some cases the auditor may have chosen to misinterpret an accounting or auditing
standard. The proposed framework considers such instances breaches of professional conduct
rather than evidence of a lack of ability.
18. Petty and Cuganesan (1996, 41) argue that a decline in auditor expertise associated with
reduced specialization might eventually lead to lower audit quality.
63The International Debate Over Mandatory Auditor Rotation

19. Neither of the two fixed engagement period analytic studies, Magee and Tseng (1990, 317) nor
Elitzur and Falk (1996a, 249) permit differing auditor abilities.
20. The lack of internal controls in the foreign exchange department allowed its manager to hide
large losses on foreign exchange contracts. The engagement partner postponed informing the
board of directors (until 1987) of his discovery at the request of the two employees, his close
personal friends. Subsequently, AWA’s board sued the auditors for negligence.
21. Large auditing firms may possess “high ability” and not require any resource depletion to
accomplish a large firm engagement. Moreover, extreme cases also are possible in which the
complexity of the client is so far beyond the ability of the auditor that ability is not affected
by fee level. However, no research evidence exits to support such scenarios or to suggest that
lower fees actually increase auditor ability.
22. If no client specific quasi-rents are expected from a given client relationship, an auditor is
indifferent to termination of the relationship. In this case, the auditor is perfectly independent
(DeAngelo, 1981a, 116).
23. These assumptions are consistent with the audit market structure literature cited herein.
24. The negative relation for the audit quality-market structure linkage (path F3 E, Figure 1) is
expected to hold for professional oversight as well, since increased regulation results from
poor audit quality.
25. In fact, the AICPA admits that ”because audits are subject to cost/benefit constraints and are
the product of human endeavor…—no audit failures whatsoever—is impossible to achieve“
(AICPA, 1992, 4).
26. Deis and Giroux (1992, 467) examine whether audit quality improves when auditors know
that their work will be subject to review by third parties and that sanctions for poor quality
work will be applied. They find that audit firms that are members of the AICPA’s Peer Review
Section conduct higher quality audits.
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