Audit firm rotation in the public sector: Implications for earnings quality

Purpose: This paper examines the effect of audit firm rotation on earnings quality in the context of local government in Australia. In the Australian state of N.S.W., compulsory audit tendering by local councils every six years was introduced in 1993, giving local councils the choice to rotate or retain their audit firm. The study examines the differences in earnings quality in the first year after the tender, between councils that retain the incumbent auditor and councils that rotate their audit firm. It also examines the differences in the quality of earnings longitudinally, for both sets of councils, over the period from 1994 to 2006.Design/Methodology/Approach: Using annual report data collected from over 150 NSW local councils between 1994 and 2006, we estimate earnings management using two methods. Patterns in the level of earnings management between groups and over time are identified by modeling earnings management as a function of various determinants of earnings quality and of the year of the tender cycle. Findings: This study finds some evidence that audit firm rotation improves earnings quality. In the first year after the tender, earnings quality is higher for councils that rotate auditors. Over the period of the audit tenure, the pattern of earnings management differs between councils that retain their audit firm and those that rotate audit firms, and it appears that rotators realize improvements in earnings quality more quickly than do retainers. There is no evidence of loss of audit quality in the year prior to the new tender.Practical Implications: This study may encourage the introduction of audit firm rotation in jurisdictions concerned with auditor independence.Originality/Value: This is the first study to examine the impact of audit firm rotation on earnings management.