Working Paper: On the Economics of Audit Partner Tenure and Rotation: Evidence from PCAOB Data

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Paper authors: Brandon Gipper, Luzi Hail, and Christian Leuz

Research focus: This paper provides the first in-depth analysis of the economic tradeoffs and the audit quality implications associated with audit partner tenure and rotation for a large sample of publicly listed U.S. firms. Previous studies have leaned heavily on small samples obtained from either foreign settings or individual audit firms due to the lack of partner name disclosure. The evidence from these studies is mixed and does not necessarily apply to the U.S. with its robust reporting and audit environment, including the five-year rotation mandate for the leading audit partners.

Limitations on partner tenure and mandatory rotations should help prevent overly close relationships between lead partners and clients and provide new perspectives on ongoing engagements (i.e., "fresh-look" benefits). At the same time, frequent mandatory rotations could potentially disrupt built-up knowledge of complex engagements and lead to a reduction in audit quality. To answer these questions, the authors examine a panel of partner-client relationships for a sample of more than 3,300 clients of the six largest U.S. audit firms over the years 2008-2014. This sample covers about half of the SEC registrants and represents more than 85 percent of aggregate U.S. market capitalization.

The authors find no evidence for a decline in the quality of audits during partner tenure and little support for fresh-look benefits after rotation. The authors, however, do find significant changes in the underlying economics of the audit engagement over the course of the partner cycle. Specifically, audit fees tend to increase and audit hours decrease with partner tenure. These systematic fee and hour changes differ with client size and partner experience, and are less pronounced in local audit markets that are highly competitive.

Combined with the audit quality results, the audit fee and hour findings suggest that audit firms attempt to minimize disruptions and audit failures around mandatory rotations. Yet, special situations like switches of the audit firm or early partner rotations seem to require more attention by the audit partners and are also more likely to exhibit audit quality effects.

Overall, the paper presents novel evidence on the economic implications and quality effects associated with partner rotation and tenure. The findings will serve as a critical baseline for future research on the role of lead partners, particularly in light of the disclosure of engagement partner names beginning in late 2017.