OR Spectrum (2011) 33:265–285
DOI 10.1007/s00291-010-0221-4
REGULAR ARTICLE
An overlooked effect of mandatory audit–firm rotation
on investigation strategies
Wuchun Chi
Published online: 1 July 2010
© Springer-Verlag 2010
Abstract Section 207 of the Sarbanes–Oxley Act of 2002 (hereafter, the SOX Act)
passed by the US Congress requires a study of mandatory auditor rotation of regis-
tered public accounting firms. In the debate over the costs and benefits of mandatory
audit–firm rotation, one cost has been overlooked: that of more aggressive monitor-
ing. Because few countries have put such mandatory rotation into practice, there is
little empirical evidence available for analysis of its costs and benefits. My research,
therefore, uses an analytical approach to demonstrate that, in a firm that has a well-
functioning independent board, as required by section 301 of the SOX Act, the board
will adopt a more aggressive strategy in investigating the collusion between the man-
ager and the auditor and pay a higher audit fee than it would have done in an envi-
ronment with no audit–firm rotation requirement. The results of this research alter the
balance between the costs and benefits of a mandatory audit–firm rotation requirement
and should not be ignored by regulators considering implementing such a requirement.
Keywords Sarbanes–Oxley Act · Audit–firm rotation · Audit fees ·
Investigation strategy
1 Introduction
Recent scandals involving accounting irregularities have damaged the credibility of
accounting audits. In an attempt to help restore this lost credibility, the US Congress
passed the Sarbanes–Oxley Act of 2002 (hereafter the SOX Act). Section 203 of this
act mandates audit–partner rotation, and section 207 requires a study of mandatory
W. Chi (
B
)

ability to develop such an understanding and ability. On the other hand, some auditing
professionals also recognize that over-familiarity may be a significant threat to audi-
tor independence. The potential impairment of auditor independence constitutes the
basic reason for requiring audit–partner and/or audit–firm rotation. In addition, new
auditors, an inevitable consequence of auditor rotation, may provide a fresh, unjaded
view of the firm during the audit process.
The SOX Act reflects these traditional views. Specifically, section 203 of the SOX
Act treats audit services as unlawful if the lead or the coordinating audit partner
provides services for five consecutive years to a certain client. In addition, section
207 of the SOX Act requires the Comptroller General to conduct a study to exam-
ine the potential effects of the mandatory rotation requirement on registered public
accounting firms within one year of the passage of the SOX Act. One can say that
section 207 suggests that mandatory audit–firm rotation may be an effective means
of restoring the credibility of the audit function. This paper examines this suggestion
1
In general, there are two types of auditor rotation: audit–partner rotation and audit–firm r otation. Since
the SOX Act has already enforced audit–partner rotation in section 203 but merely calls for the study of
audit–firm rotation, this paper focuses on audit–firm rotation. For simplicity, in this article, “mandatory rota-
tion” refers to audit–firm rotation rather than to audit–partner rotation. Following the requirements of SOX
207, the Government Accountability Office (formerly the Government Accounting Office) is responsible
for studying the effectiveness and implications of audit firm rotation.
2
The idea of mandatory auditor rotation existed prior to recent reforms. In fact, the Report of the
Commission on Auditors’ Responsibilities (The Cohen Commission) (1978) recommended mandatory
rotation. The Cohen Report reasons that “[s]ince the tenure of the independent auditor would be limited,
the auditor’s incentive for resisting pressure from management would be increased” (p. 108).
123
An overlooked effect of mandatory audit–firm rotation 267
by focusing on the economic costs of mandatory audit–firm rotation while taking into
account the enhanced role of an independent board (or an independent audit com-

3
Although manager–auditor side payments were generally prohibited even before the SOX Act, Lee and
Gu (1998) indicate that side payments could take several forms, some of which were prima facie legal (e.g.,
the auditor might be appointed by the manager on behalf of the shareholders and the manager could use
the appointment itself as a side payment to sway the auditor) and some of which might be legally justified
(e.g., granting the auditor with consulting contracts). Generally, preventing or detecting side payments can
be legally difficult and expensive. See Footnote 5 (p. 536) of Lee and Gu (1998) for a detailed discussion
of potential side payments between the manager and the auditor. The SOX Act of 2002 has added more
restrictions on such side payments, prohibiting, for example, most types of consulting and the hiring of
former auditors by the audited firms within a year of the audit(United States Code 2002). A public account-
ing firm can, however, still perform non-auditing services, such as tax services. Some recent studies provide
circumstantial evidence that tax services can be a channel for side payments. Dhaliwa et al. (2004), for
example, find that changes in effective tax rates (ETR) between the third and fourth quarters are related
to efforts toward earnings management. Omer et al. (2006) further find that one-year-ahead marginal tax
rate and ETR reductions are associated with higher tax-service fees paid to the audit firms. Although this
evidence is not definitive, it suggests that, despite the provisions of the SOX Act, there may exist channels
for managers to deliver side payments to auditors.
123
268 W. Chi
the costs of auditor rotation in the context of an independent audit committee become
clear.
The remainder of the paper is organized as follows. Section 2 reviews the debate
on auditor independence, tenure, and mandatory rotation. Section 3 describes the audit
pricing model and the investigation strategy of the audit committee in
non-rotation-required and rotation-required environments. Section 4 discusses the
solution and explains the economic consequences of mandatory rotation. I present
concluding remarks in Sect. 5.
2 The debate
Since independence is the cornerstone of the auditing function, both legislators and
financial statement users are highly concerned with this issue. To reduce the potential

rience. The report also recommends that everyone on the audit committee (members and non-members of
management alike) should receive training both with respect to their general responsibilities and regarding
the operations, business issues, financial reporting, control systems, and risk management processes of the
company itself.
123
An overlooked effect of mandatory audit–firm rotation 269
of an effective audit committee in discussing the merits of the mandatory rotation
requirement.
5
In a situation where section 301 of the SOX Act is actually enforced, I assume that
the possibility that management might threaten the audit firm is eliminated. That is,
this paper analyzes the r esult of a theoretical effectiveness of section 301 of the SOX
Act and assumes that the concerns over enforcement expressed in the past literature,
such as those over managers’ improper influence on auditors due to auditors’ fear
of losing clients due to disagreement with managers’ financial reporting preferences
(e.g., Farmer et al. 1987).
6
Cautious optimism about the effective enforcement of Sec-
tion 301 is justified by recently issued auditing standards that require communication
between auditors and audit committees about unrecorded misstatements (SAS No.
89, American Institute of Certified Public Accountants (AICPA) 1999a) and the audi-
tor’s judgment about the quality, not just the acceptability, of accounting principles
and underlying estimates in the financial statements (SAS No. 90, American Institute
of Certified Public Accountants (AICPA) 1999b). Those requirements enhance the
importance of the audit committee, giving it a critical role that dominates the role
of managers in affecting the outcome of accounting negotiations with the client. In
summary, auditor rotation becomes less pivotal in a situation where there exists a well
functioning independent board (or independent audit committee) as required by the
SOX Act than in a pre-SOX Act environment where auditors can never be completely
independent.

financial reporting ( Carcello and Nagy 2004). In addition, studies investigating the relation between audit
firm tenure and perceptions of earnings quality include Mansietal.(2004), who use the cost of debt financ-
ing to proxy for creditor perceptions, and Ghosh and Moon (2005), who use earnings response coefficients
123
270 W. Chi
and thus lowers the quality of financial reporting. In addition, the National Com-
mission on Fraudulent Financial Reporting (The Treadway Commission) (1987) has
recommended that the peer review program of the AICPA’s SEC Practice Section pay
closer attention to the first-year audits of public clients. This recommendation was
made partly because the Commission’s review of fraud-related cases revealed that
a significant number of those cases involved companies that had recently changed
auditors (p. 54). Further, the Quality Control Inquiry Committee of the AICPA’s SEC
Practice Section found that audit failure occurs almost three times as often on first- or
second-year audits (American Institute of Certified Public Accountants(AICPA) 1992).
In summary, these investigations suggest that mandatory rotation could diminish audit
effectiveness and thus lower the quality of financial reporting.
In spite of the existing empirical evidence, there are at least two reasons to examine
the issue via the analytical approach. First, the results of the empirical studies (e.g.
Johnson et al. 2002; Myers et al. 2003; Ghosh and Moon 2005; Chen et al. 2008)were
found in a legal environment that did not require audit firm rotation. An analytical
analysis can provide supplemental arguments and another perspective to complement
prior empirical evidence. Second, audit quality is determined by separate factors: the
auditor’s ability to discover errors or breaches, and the degree of independence required
to report the errors truthfully (DeAngelo 1981). All existing empirical evidence, how-
ever, is based on a joint test of auditors’ independence and ability. To address how
mandatory rotation affects auditor independence and audit pricing, I assume that audit
effort is unchanged either in a rotation-required or non-rotation-required environment.
In the next section, I simplify the model of Lee and Gu (1998) to examine the costs
associated with mandatory auditor rotation, particularly monitoring costs and audit
fee payments. The focus of the Lee and Gu (1998) study is to examine the relationship

= F
NR
(for
n ≥ 2), the audit fee for subsequent periods. Further, there is a constant component
to audit cost in each period, A
n
= A (for n ≥ 2), and a start-up cost, K , in the initial
period so that A
1
= A + K represents the initial audit. A client who switches his or
her auditor incurs a transaction cost, denoted by S. Finally, r is the discount rate that
applies to the auditor’s future profits.
Fact 1: In a non-rotation environment:
1. The audit fee on the initial engagement is F
∗
1;NR
= A + K −
K+S
1+r
,
2. The audit fee on all subsequent audits F
∗
NR
= A +
r
1+r
(K + S), and
3. F
∗
NR

In other
words, the entire calculation of profit from collusion includes three parts: the periods
before collusion is detected, during each of which some profit should be expected; the
9
To focus on the issue of mandatory rotation, I treat the side payment B exogenously for tractability.
10
To examine how mandatory rotation affects the auditor’s independence, I omit the penalty on the
manager.
123
272 W. Chi
period when collusion is detected, which will result in a penalty; and the periods after
collusion has been detected, during which the profit from collusion will be zero.
I will start by describing the auditor’s strategy—a pure strategy either of indepen-
dence or collusion—in the non-initial period. If the auditor does not collude with the
manager, the present value of his total profits is:
(F
NR
− A)(1 + r)
r
. (1)
However, when he colludes with the manager, the auditor receives a payoff B +
F
NR
− A with probability (1 − π
NR
) + π
NR
(1 − p), since the board could either not
investigate (with probability 1 − π
NR

1 − π
NR
· p
1 + r

2
+···

=
[
(1 − π
NR
· p)(B + F
NR
− A) − π
NR
· p · D
]
·
1 + r
r + π
NR
· p
. (2)
The probability factor must be included for each period, because it is only by surviv-
ing previous periods (each of which involves its own probability) that an auditor will
be able to participate in any following period (each of which, again, involves its own
probability). In other words, a particular payoff depends upon an auditor surviving
previous periods as well as the current one. Recall that the expected present value of
profits for an auditor who chooses an independent strategy is given by Eq. (1). Letting

NR
· p)(B + F
NR
− A) − π
NR
· p · D]·
1 + r
r + π
NR
· p

. (3)
A positive result for Eq. (3) means that an independent strategy—one free from
collusion—is the best course of action for the auditor in a non-initial period. On the
other hand, to collude with the manager is the auditor’s rational behavior for a negative
Y . Taking the partial derivative of Eq. (3) with respect to F
NR
− A and B yields:
∂Y
∂(F
NR
− A)
=
(1 + r)
2
π
NR
· p
r(r + π
NR

=
1
p
·
B
B +
1+r
r
(F
NR
− A) + D
. (6)
Substituting F
∗
NR
from Fact 1 into Eq. (6) yields:
π
∗
NR
=
1
p
·
B
B + K + S + D
. (7)
Equations (6) and (7) readily show that the higher the probability p or the audit profit
during the non-initial periods, F
NR
− A, the lower the probability that the board will

,is:
π
∗
1;NR
=
B
p · (B + D)
. (8)
Equation (7) subtracted from Eq. (8) yields:
π
∗
1;NR
− π
∗
NR
=
1
p
·

B · (K + S)
(B + D) · (B + K + S + D)

> 0. (9)
Equation (9) s hows that the board’s investigation effort is highest in the initial period.
Along with Fact 1, which shows that the audit fee increases after the initial period,
this equation offers a simplified version of the findings in Lee and Gu (1998).
14
Iuse
the results from this section as a benchmark to compare with an environment with

mittee in a non-rotation environment in each period in terms of side payments (B),
penalties to the auditor for collusion with the manager (D), and the probability of
discovery of misconduct (p); for periods after the initial one, the auditor’s set-up costs
(K) and the client’s switching costs (S) are added.
3.2 The optimal investigation strategy in a rotation-required environment
To analyze how mandatory rotation affects the board’s investigation strategy in each
period, I use π
n;R
(N) to represent the mixed strategy in period n (1 ≤ n ≤ N), where
13
Ideally, this formula should be expressed as (1 − p·π
1;NR
)· (B+ Present Value of an Audit Engagement
in an Initial Year) −π
1;NR
· (pD). However, assuming a zero-profit audit market, the term Present Value
of an Audit Engagement in an Initial Year, reduces to zero.
14
The fact that the fee in the initial period is lower than in subsequent periods is what is commonly referred
to as “low-balling” or “low introductory pricing.” As compared to legal enforcement and investigation strat-
egy , Lee and Gu (1998) explain that low-balling itself is an economical mechanism to self-fulfilled auditor
independence. In Sect. 3.2, I will show that mandatory rotation interferes with this mechanism.
123
An overlooked effect of mandatory audit–firm rotation 275
1 is the initial period and N is the imposed limit on the maximum length of a given
auditor–client relationship in a rotation-required environment (denoted by R). Let
F
n;R
(N) be the audit fee in period n and 
n;R

present value condition shows that the present value of the auditor’s profit in period
n equals his audit profit in the current period plus the present value of the profit in
period n + 1 discounted to period n;thecompetition condition reflects the assumption
of a highly competitive audit market.
15
By the method of backward induction, the board adopts an optimal mixed strategy
π
∗
N;R
(N) that makes the auditor indifferent to the choice between independence and
collusion at the terminal audit period N. That is:

N;R
(N) =[1 − p · π
∗
N;R
(N)]·[B + 
N;R
(N)]− p · D · π
∗
N;R
(N). (14)
The left hand side of the equation shown above is the expected utility of the auditor
who adopts an independent strategy, and the right hand side is his expected utility
under a collusion strategy. Rearranging the terms gives the result
π
∗
N;R
(N) =
1

(N) =[1 − p · π
∗
N−1;R
(N)]
·[B + 
N−1;R
(N)]− p · D · π
∗
N−1;R
(N), (16)
and
π
∗
N−1;R
(N) =
1
p
·
B
B + 
N−1;R
(N) + D
. (17)
Using the same procedure, to prevent collusion, the board’s optimal mixed strategy of
π
∗
n;R
(N) satisfies the condition:
π
∗

(P − A − K ). The subsequent parts show that when the bidder becomes an incumbent
auditor, he has a pricing advantage S and a cost advantage K as compared to all his
rivals. The terms sum to zero due to the constraint of the competition condition in the
audit market. After rearranging, the bidder’s offering price is given by:
P = (A − S) +
(S + K ) · r · (1 + r)
N−1
(1 + r)
N
− 1
. (20)
Given the incumbent auditor’s pricing advantage, S, the audit fee during the non-initial
auditing period is P + S. In particular,
F
∗
2;R
(N) = F
∗
3;R
(N) =···= F
∗
N;R
(N) = F
∗
R
(N) = P + S, (21)
which can be written as
F
∗
R

(N) = S, is the same in both rotation-required and non-rotation
required environments.
Proposition 2 For an environment with mandatory rotation:
π
∗
1;R
(N) =
1
p
·
B
B + D
, and (24)
π
∗
n;R
(N) =
1
p
·
⎧
⎨
⎩
B
B + D + (S + K ) ·
(1+r)
N
−(1+r)
n−1
(1+r)

B+D
1
p
⎧
⎨
⎩
B
B+D+(S+K )·
(1+r)
N
−(1+r)
n+1
(1+r)
N
−1
⎫
⎬
⎭
Non-rotation
1
p
·
B
B+D
1
p
·
B
B+K +S+D
N is the maximum length of the auditor–client relationship and n (2 ≤ n ≤ N) is a given auditing period

R
n+1
(N)]−[π
R
n+1
(N) − π
R
n
(N)] > 0.
3. Whether rotation is required or not, the board’s optimal investigation strategy is
the same in the initial auditing period. However, in all subsequent periods, the
board should adopt a more aggressive investigation strategy in a rotation-required
environment. Specifically, π
∗
1;R
(N) − π
∗
1;NR
= 0 and π
∗
n;R
(N) − π
∗
NR
> 0.
4. In a rotation-required environment where N is variable, the investigation level
in a fixed period n is a decreasing function of N. Specifically, π
∗
n;R
(N + 1) −

regimes.
123
An overlooked effect of mandatory audit–firm rotation 279
Table 2 Summary of the auditing pricing
∗
Initial period Non-initial period
Rotation-required (A − S) +
(S+K )·r·(1+r)
N−1
(1+r)
N
−1
A +
(S+K )·r·(1+r)
N−1
(1+r)
N
−1
Non-rotation A + K −
K+S
1+r
A +
r·(K +S)
1+r
N is the maximum length of the auditor-client relationship
In fact, the reason why investigation strategies π
NR
and π
R
are different at n ≥ 2,

and F
∗
n;R
(N)>F
∗
N
R.
2. In a rotation-required environment, both the initial audit fee F
∗
1;R
(N) and the
non-initial audit fee F
∗
n;R
(N) are decreasing functions of N.
Proof See Appendix 4.
I use Fig. 2 to illustrate the intuition of Proposition 4. The horizontal axis measures
the auditing period n, and the vertical axis measures the corresponding audit fee. The
bold lines reveal the audit fee in rotation-required environments with a shorter and a
longer period of rotation, and the thin line portrays the fee in a non-rotation-required
environment. Although the cost advantage of the incumbent auditors allows for a lower
initial period fee in both the two rotation-required environments and the non-rotation
required environment, the auditing price is higher in an environment with mandatory
auditor rotation. Briefly stated, in terms of audit fee payment, the mandatory rotation
requirement represents a cost burden to the firm.
17
In fact, the conclusion is not subject to the discounted zero-profit assumption, as long as the present
value of the initial engagement in a non-rotation-required regime is constant. That is, if we compare the
rotation-required to the non-rotation-required environment, the auditor’s profit in each non-initial period is
different; however, if the present values of an initial engagement in the two environments are the same, the

out required rotation. These findings have some general methodological ramifications.
Specifically, it is not realistic to examine the role of the auditor in isolation from the
board or auditing committee, for, under section 301 of the SOX Act, the quality of
financial reporting is not the responsibility of the auditor alone, but is shared by the
board. Therefore, the debate over the effectiveness of mandatory audit–firm rotation
should include consideration of the role of the board. Since familiarity with the client
is vital to an effective audit process, the mandatory audit–firm rotation requirement—
which was instituted to address concerns about excess familiarity—may in fact reduce
the quality of financial reporting by making it impossible for an auditor to accumulate
valuable familiarity. In cases where the effective implementation of SOX 301 results
in higher audit fee payment and causes the board to adopt a more aggressive strategy
123
An overlooked effect of mandatory audit–firm rotation 281
to prevent collusion between manager and auditor, legislation that is aimed at pro-
tecting the public interest may indeed harm it by imposing economic costs that can
be avoided in the presence of well-functioning audit committees. I t is important to
remember that the conclusions of this study are based on the critical assumption that
firms have qualified audit committees ready to take responsibility for the auditing
process. Accordingly, a policy implication of this paper is that it is more worthwhile
to enhance the real function of audit committees rather than to focus on audit–firm
rotation.
Several cautions should be emphasized. The conclusion of this study is based on
the premise that SOX 301 is effectively enforced, but the paper does not attempt to
argue that this is in fact the case. In addition, the potential agency costs that exist
between the audit committee and investors may leave a role for mandatory auditor
rotation even in a post-SOX environment. Finally, the analysis of this paper does not
include the costs of enhancing the functioning of audit committees.
Acknowledgments I wish to thank the National Science Council for its generous financial assistance.
Appendix 1: A simple description of DeAngelo’s Model (1981)
Under a non-rotation environment, , the present value of the auditor’s profit in the

r
≤ ( A + K) +
A
r
+ S. (A1-2)
In particular, K and S determine the incumbent value of the auditors. For a profit-
maximizing auditor who extracts all the quasi-rent, Eq. (A1-2) can be rewritten thus:
F
∗
NR
= A +
r · (K + S)
1 + r
.
Finally, competition in the audit market implies that:
(F
∗
1;NR
− A
1
) +
F
∗
n;NR
− A
r
= 0 ⇒ F
∗
1;NR
= A + K −

∗
R
(N) − A
(1 + r)
+
F
∗
R
(N) − A
(1 + r)
2
+···+
F
∗
R
(N) − A
(1 + r)
N−n
=
F
∗
R
(N) − A
(1 + r)
N−n
·

1 + (1 + r) + (1 + r)
2
+···+(1 + r)

N−n
)
⎫
⎬
⎭
·
(1 + r)
N−n+1
− 1
r
=
S + K
(1 + r)
N
− 1
·

(1 + r)
N
− (1 + r)
n−1

.
Substituting the above 
n
into Eq. (9), I get that:
π
∗
n;R
(N) =

∗
1;R
(N)>π
∗
n;R
(N) is obvious.
Proof of Proposition 3-2: From Proposition 2:
π
n;R(N)
=
B
p
B + D +
S+K
(1+r)
N
−1
·[(1 + r)
N
− (1 + r)
n−1
]
=
k
1
k
2
+ k
3
· f (n)

2
· (1 + r)
n−1
< 0.
123
An overlooked effect of mandatory audit–firm rotation 283
4. f (n) ·[f (n + 1) − f (n + 2)]+ f (n + 2) ·[f (n + 1) − f (n)] > 0.
proof :
First, multiply fact (3) by − f (n + 2), to get the result
f (n + 2) ·[f (n + 1) − f (n + 2)]+ f (n + 2) ·[f (n + 1) − f (n)] > 0.
Next, use the fact that f (n)> f
(n + 2)>0 (from fact 2) and [ f (n + 1) − f (n +
2)] > 0 to find
f (n) ·[f (n + 1) − f (n + 2)]+ f (n + 2) ·[f (n + 1) − f (n)] > 0.
5. π
n+1;R
(N) − π
n;R
(N) =
−k
1
k
3
[ f (n+1)− f (n)]
[k
2
+k
3
f (n+1)]·[k
2

3
{ f (n)[ f (n+1)− f (n+2 )]+ f (n+2)[ f (n+1)− f (n)]}

[k
2
+k
3
f (n+2)]·[k
2
+k
3
f (n+1)]·[k
2
+k
3
f (n)]
> 0.
Proof of Proposition 3-3 The first part is obvious. In addition,
π
∗
n;R
− pi
∗
n;NR
=
1
p
·
B(S + K )(1 − γ)
[B + D + (S + K) · γ ]·[B + K + S + D]

n;R
(N) and F
∗
NR
depend on the relative sizes of
(1+r)
N−1
(1+r)
N
−1
and
1
1+r
. Because
(1 + r)
N−1
(1 + r)
N
− 1
−
1
1 + r
=
1
(1 + r) −
1
(1+r)
N−1
−
1

(N)>F
∗
1;NR
.
Proof of Proposition 4-2: From the formulas of F
∗
1;R
(N) and F
∗
n;R
(N),itiseasyto
see that they relate to Nviathe factor:
(1 + r)
N−1
(1 + r)
N
− 1
=
1
(1 + r) −
1
(1+r)
N−1
.
123
284 W. Chi
Hence, it is straightforward to get the result that either F
∗
1;R
(N) or F

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