Audit Retendering and Mandatory Auditor Rotation

Abstract

Building on an auction model, we examine the economic consequences of audit retendering, under which the incumbent auditor in auction possesses both an information advantage and knowledge advantage over outside auditors. Audit retendering allows the firm to retain the incumbent auditor with positive probability, but expect to pay information rent to the incumbent auditor due to his information advantage over outside auditors. In equilibrium, auditor switching (or no switching) under audit retendering conveys additional information to investors, and therefore the informativeness of the audit report under audit retendering is always greater than that under mandatory auditor rotation. We identify conditions under which client firms may benefit from audit retendering. Our findings shed light on the recent European Union Audit Reform, which adopts audit retendering as an alternative to auditor rotation, and have implications to the Public Company Accounting Oversight Board, which are evaluating the proposed mandatory auditor rotation.