Anticipation of Mandatory Audit Firm Rotation and Audit Quality

Researchers and regulators have continuously debated whether mandatory audit firm rotation improves or impairs audit quality. Theoretically, rotation might improve auditor independence, but may impair auditor competence, because the new auditor lacks client-specific knowledge. In 2014, the European Commission mandated audit firm rotation for public-interest entities, starting from 2020 for non-financial firms. However, many firms anticipated the regulation and decided to rotate early. This behavior provides a unique setting because auditors have strong incentives to build a reputation of high quality audits when they choose to participate in the market for early rotations. Using a balanced panel of 287 German firms and data from 2014 to 2019, we hypothesize and find lower discretionary and abnormal working capital accruals in the first year after rotation. This effect is restricted to smaller public companies not listed in the regulated market of Frankfurt Stock exchange and does not persist in the following years. In supplemental analyses, we find significantly longer audit report lags, but no association with audit fees