How Do Various Forms of Auditor Rotation Affect Audit Quality? Evidence From China

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The International Journal of Accounting

47 (2012) 109 138
How Do Various Forms of Auditor Rotation Affect

Audit Quality? Evidence from China
Michael Firth a , Oliver M. Rui b,, Xi Wu c
a
Department of Finance and Insurance, Lingnan University, Hong Kong

b
China Europe International Business School, China
School of Accountancy, Central University of Finance and Economics, China
Received 8 June 2010
Abstract
The Enron/Arthur Andersen scandal has raised concerns internationally about auditor independence, audit quality, and the need for regulatory action such as mandatory auditor rotation. China's
unique institutional features provide a setting in which we can compare comprehensively the various forms of auditor rotation at different levels (partner vs. rm) and in different settings (voluntary
vs. mandatory). In addition, institutional conditions vary dramatically across China, which provides
us with an opportunity to test whether the development of market and legal institutions affects the
impact of rotation on audit quality. We expect that auditors are less (more) constrained by market
forces and less (more) self-disciplined to maintain audit quality in regions with less (more) developed market and legal institutions. Therefore, mandatory rotation may play a more (less) important
role in less (more) developed regions. Using auditors' propensity to issue a modied audit opinion
(MAO) as a proxy for audit quality, we nd that rms with mandatory audit partner rotations are
associated with a signicantly higher likelihood of an MAO than are no-rotation rms. However,
this effect is restricted to rms located in less developed regions. We nd similar evidence for voluntary audit rm rotation although the signicance level is much weaker than for mandatory partner
We appreciate the very helpful comments and suggestions of Rashad Abdel-khalik (Editor), Roger Simnett
(Co-Editor), three anonymous reviewers, Chee Chow, Mark DeFond, and T. J. Wong. Michael Firth acknowledges financial support from the Government of the HKSAR (GRF340408). Oliver Rui acknowledges financial
support from the Government of the HKSAR (CUHK450009). Xi Wu acknowledges financial support from the
National Natural Science Foundation of China (No. 70602020), the Program for Innovation Research at the Central University of Finance and Economics (CUFE), the Beijing Municipal Commission of Education Joint Construction Project, and the Project 211 Fund of CUFE.
Corresponding author.
E-mail addresses: marth@ln.edu.hk (M. Firth), oliver@ceibs.edu (O.M. Rui), wuxi@cufe.edu.cn (X. Wu).
0020-7063/$ - see front matter 2012 University of Illinois. All rights reserved.
doi:10.1016/j.intacc.2011.12.006
110
M. Firth et al. / The International Journal of Accounting 47 (2012) 109138
rotation. Other forms of auditor rotations (i.e., mandatory audit rm rotation and voluntary audit
partner rotation), have no effect on MAOs.
2012 University of Illinois. All rights reserved.
Keywords: Mandatory audit partner rotation; Mandatory audit rm rotation; Voluntary rotation; Market and legal
institutions; Modied audit opinion
1. Introduction
This paper examines how various forms of auditor rotation (partner level vs. firm level;
mandatory vs. voluntary) affect audit quality in the Chinese capital market setting. The
collapse of Enron and its auditor, Arthur Andersen, quickly led regulators worldwide to
consider different mechanisms for enhancing auditor independence. Legislators, regulators, and professional organizations around the world have suggested mandatory auditor
rotation at both the partner and the firm level as a potential means to reduce clientauditor
familiarity and introduce fresh perspectives, thereby enhancing auditor independence and
audit quality (e.g., General Accounting Office (GAO), 2003). The typical counterarguments for this suggestion are that auditors have economic incentives to maintain
their independence (DeAngelo, 1981; Reynolds & Francis, 2001) and that audit quality
may be lower for new engagements due to the lack of knowledge about the client
(Carcello & Nagy, 2004; Daugherty, Dickens, & Higgs, 2010; Geiger & Raghunandan,
2002). 1
Several jurisdictions have implemented mandatory audit partner rotation, including in the
United States, where Section 203 of the Sarbanes-Oxley Act of 2002 states that the partner
with the primary responsibility for the audit (and the reviewing partner) cannot perform
these duties for more than five consecutive years. Although the policy of mandatory audit
firm rotation has not been widely adopted, 2 the Sarbanes-Oxley Act called for further
research into its potential effects, and there is a very real possibility that mandatory rotation
might again be proposed in the future by major regulators such as the U.S. Securities and Exchange Commission (SEC) (DeFond & Francis, 2005, p.16). More recently, the European
Commission (2010, p.11) in a Green Paper, states that the mandatory rotation of audit
firms not just of audit partners should be consideredwith a view to instilling and maintaining objectivity and dynamism in the audit market. Although there is a lively debate on the
merits of auditor rotation within the accounting and investment professions and in the financial media, there is relatively little rigorous research on the matter. Our study seeks to remedy
this situation by examining audit firm and audit partner rotation in China, and we seek to contribute to the auditor rotation literature and policy debate in several ways.
First, rather than measuring the impact of audit tenure on audit quality, which has been
the focus of much prior research, our study emphasizes mandatory and voluntary auditor
1
However, these arguments are less likely to apply in the case of audit partner rotation because of the continuity
of audit rm-specic audit methodologies, know-how, and most members of the audit rm.
2
So far, few countries have adopted a mandatory audit rm rotation policy. Those that have, include Brazil, India, Italy, Singapore, and South Korea (Cameran, Vincenzo, & Merlotti, 2005).
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rotation. By way of background, there are two main issues in the debate surrounding mandatory auditor rotation. One is that long audit tenure could impair actual or perceived auditor independence, i.e., the tenure perspective (e.g., Carey & Simnett, 2006; Johnson,
Khurana, & Reynolds, 2002; Myers, Myers, & Omer, 2003), and the other is that a new
auditor could provide a fresh look, i.e., the rotation perspective (e.g., Chi, Huang, Liao,
& Xie, 2009; Dopuch, King, & Schwartz, 2001; Hamilton, Ruddock, Stokes, & Taylor,
2005). 3 While most prior related studies have focused on the first perspective, few empirical studies have directly examined the issue from the latter perspective. Our study examines the effect of auditor rotation on auditor independence and therefore adds to the related
literature from the rotation perspective.
Second, although recent studies have explored auditor rotation, limited effort has been
made to compare comprehensively these forms at different levels (partner vs. firm) and in
different settings (voluntary vs. mandatory). This is partly due to the lack of appropriate
data. In China, auditors are required to sign their names on audit reports (Chen, Su, &
Wu, 2009; Chen, Sun, & Wu, 2010), thus making (voluntary) audit partner rotation publicly identifiable. China's regulators issued a requirement for mandatory audit partner rotation in October 2003, which enables us to identify mandatory audit partner rotation
since the 2003 annual audit. China also has mandatory audit firm rotations due to the cessation of former audit firms (similar to the widely-tested setting of the Arthur Andersen
collapse), or a particular Chinese regulator mandates the move to another audit firm.
The unique institutional and disclosure features in China provide us with a setting in
which we can compare comprehensively the various forms of auditor rotation at different
levels and in different settings. It also provides evidence on whether mandatory audit firm
rotation is superior to other forms of auditor rotation (including mandatory audit partner
rotation). Our findings offer important insights currently missing from the debate on mandatory auditor rotation.
Third, recent research has shown that institutional factors 4 can help explain differences
in accounting quality across countries (Ball, Kothari, & Robin, 2000; Bushman, Piotroski,
& Smith, 2004; Leuz, Nanda, & Wysocki, 2003). Other scholars extend this literature by
researching whether there are differences in audit quality across countries (Choi &
Wong, 2007; Francis, Khurana, & Pereira, 2003; Francis & Wang, 2008; Khurana &
Raman, 2004). We further extend this field by examining whether there are differences
in audit quality across the different regions within a large but diverse country. One important characteristic of China's reforms is the very uneven economic and legal development
across the country. We believe that the differences in regional development can have profound effects on auditing (including auditor rotation). In our examination, we explicitly account for market development using a set of indexes that is designed to capture differences
in economic, political, legal, and institutional factors across regions. We expect that in less
developed regions, auditors are less constrained by market forces and have less selfdiscipline to maintain audit quality. In contrast, auditors face greater constraints from
3
A more detailed literature review is provided in the next section.

Institutional factors include prevailing economic conditions, the way that rms are governed, institutional and
regulatory frameworks, and the legal environment (investor protection, capital market pressures, legal
enforcement).
4
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market forces and are more motivated to self-maintain audit quality in well developed regions. Therefore, mandatory auditor rotation may play a more (less) pronounced role in regions with less (more) developed market and legal institutions.
Using Chinese data, we find that firms with mandatory audit partner rotations are associated with a significantly higher likelihood of an MAO than are no-rotation firms. However, this effect is restricted to firms located in less developed regions. We find similar
evidence for voluntary audit firm rotation, although the significance level is much weaker
than for mandatory partner rotation. Overall, we document a positive effect of mandatory
audit partner rotation on audit quality for firms located in regions with weak legal institutions. However, we do not find robust evidence that mandatory audit firm rotation is more
effective than other forms of auditor rotation in enhancing audit quality.
The findings of our study have important implications for policymakers, auditors, multinational firms, and users of financial reports. As the rapid growth of China's economy
gains global recognition, the Chinese stock market is capturing the attention of international investors. One important question that international institutional investors who enter the
Chinese stock market must consider is whether the auditors and related arrangements (such
as mandatory auditor rotations) play an effective role in mitigating information asymmetry.
Given that other transitional and emerging markets exhibit some similar characteristics to
China (e.g., poor legal and market infrastructure), our results may have some resonance for
these countries.
Furthermore, this study sheds some light on the debate about the boundaries of securities regulation. Many scholars support the helping hand theory of regulation, which argues
that regulation by means such as mandatory audit rotation is beneficial, because it protects
investors and promotes the growth of markets by increasing the supply of reliable information. However, the followers of Coase (1960) have raised a number of criticisms against
this public interest theory of regulation. They believe that markets and private actions
can take care of most market failures without the need for government intervention. Reputations, contracts, and tort law are sufficient to make markets work. The results of our
study suggest that government intervention, such as mandatory audit partner rotation,
may be effective particularly in less developed regions where law enforcement and the
legal environment are weaker. In contrast, mandatory audit firm rotation does not appear
to have clear benefits.
The rest of this paper proceeds as follows. The next section reviews the extant literature,
outlines the institutional background in China, and develops the research questions.
Section 3 discusses the research design. Section 4 describes the sample selection, composition, and descriptive statistics. Section 5 presents the main empirical results. Section 6 describes the results from sensitivity and additional tests. Section 7 concludes the paper.
2. Literature review, institutional background, and research questions
2.1. Framework of analysis
Prior literature defines audit quality as the joint probability that an auditor will both discover a breach in the client's accounting system and report that breach (DeAngelo, 1981).
Therefore, an auditor's competence and independence are two important components of
113
audit quality. However, the long-tenure association between the audit personnel/firm and
the client may give rise to concerns about familiarity and self-interest threats to auditor independence (e.g., Mautz & Sharaf, 1961; International Ethics Standards Board for
Accountants (IESBA), 2009). There are two mechanisms to address this concern. One
mechanism is the regulatory intervention into the audit firm's quality control process,
which intensified greatly after the Sarbanes-Oxley Act of 2002 (as discussed earlier).
Mandatory audit partner rotation has been implemented in the U.S. and some other jurisdictions, while mandatory audit firm rotation has been adopted by just a few countries
around the world. The other mechanism is the auditing profession itself, as audit firms
have market and economic incentives to maintain their own reputation (DeAngelo,
1981; DeFond & Francis, 2005; Reynolds & Francis, 2001). For example, voluntary
audit partner rotation within an audit firm is frequently suggested by professional accounting bodies to be a safeguard to reduce the potential compromise of auditor independence
(e.g., IESBA, 2009).
Based on arguments in the prior related literature (e.g., Carey & Simnett, 2006;
Dopuch et al., 2001; Johnson et al., 2002; Myers et al., 2003) and policy debates (e.g.,
GAO, 2003), various forms of auditor rotation have different impacts on the two components of audit quality. Relative to an audit partner rotation within an audit firm, an audit
firm rotation has a greater potential to reduce the familiarity between the auditor and the
client, thus increasing auditor independence to a greater extent. However, audit firm rotation can lead to a loss of client-specific knowledge, thus decreasing auditor competence
compared to an audit partner rotation. A mandatory rotation leaves less discretion for
the audit partner/firm to remain with the client (relative to a voluntary rotation), thus introducing a greater degree of independence; however, it also causes a sudden separation
of previously accumulated client-specific knowledge and could mask client-specific signals that are likely delivered through a voluntary auditor rotation (Johnson & Lys,
1990; Shu, 2000).
In short, introducing an auditor rotation either at partner level or firm level, either in a
mandatory or a voluntary setting, has both beneficial and deleterious effects on the two
components of audit quality. Therefore, it is an empirical question which form(s) of auditor
rotation can bring a net benefit to audit quality.
2.2. Prior literature
Many recent studies examine whether longer auditor tenure is associated with reduced
(actual) financial reporting quality (FRQ) or audit quality (AQ), either at the audit firm
level (Carcello & Nagy, 2004; Davis, Soo, & Trompeter, 2009; Geiger & Raghunandan,
2002; Gul, Fung, & Jaggi, 2009; Gul, Jaggi, & Krishnan, 2007; Jenkins & Velury, 2008;
Johnson et al., 2002; Knechel & Vanstraelen, 2007; Myers et al., 2003; Stanley &
DeZoort, 2007), at the audit partner level (Carey & Simnett, 2006; Manry, Mock, &
Turner, 2008), or at both levels (Chen, Lin, & Lin, 2008; Chi & Huang, 2005). Most of
these studies document a positive association between auditor tenure and FRQ/AQ,
while a few of them find a negative association under certain conditions, such as excessively long tenure (Chi & Huang, 2005), certain audit quality proxies (Carey & Simnett, 2006),
or in the pre-SOX period but not in the post-SOX period (Davis et al., 2009).
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As to whether mandatory auditor rotation enhances actual FRQ/AQ, a number of recent

archival studies take advantage of the mandatory audit-firm rotation setting due to the U.S.
Arthur Andersen collapse in 2002. However, their results are inconclusive. For example,
some find that mandatory audit firm rotation is associated with enhanced FRQ/AQ
(Cahan & Zhang, 2006; Krishnan, 2007; Nagy, 2005), while others do not (Blouin,
Grein, & Roundtree, 2007; Krishnan, Raghunandan, & Yang, 2007). 5 The results based
on mandatory audit firm rotations in jurisdictions outside the U.S. are also mixed. For example, Kim and Yi (2009) document a positive effect of mandatory firm rotation on FRQ/
AQ in Korea, whereas Ruiz-Barbadillo, Gmez-Aguilar, and Carrera (2009) find no such
effect in their study of Spanish firms. On the other hand, there has been limited archival
evidence regarding the effect of mandatory audit partner rotation on FRQ/AQ. As a notable
exception, Chi et al. (2009), using data from Taiwan, find no association between mandatory audit partner rotation and actual FRQ/AQ.
Overall, the evidence on the effect of various forms of auditor rotation on actual audit
quality is inconclusive. Moreover, there have been limited efforts to compare comprehensively these forms of rotation at different levels (partner vs. firm) and in different settings
(voluntary vs. mandatory), and more research is warranted. 6 In light of these shortcomings,
we undertake our study of auditor rotation using data from China. In doing so, we directly
test the arguments for and against mandatory auditor rotation. 7
2.3. China's institutional background
The Chinese audit profession is managed by the Chinese Institute of Certified Public
Accountants (CICPA) and the Ministry of Finance (MOF) of China, and is jointly regulated for capital market practices by the China Securities Regulatory Commission (CSRC)
and the MOF. Before 1996, all Chinese audit firms were affiliated with government agencies, government-sponsored bodies, or universities and research institutions. Auditors'
5
Prior experimental studies tend to suggest that mandatory auditor rotation does enhance audit quality (Dopuch
et al., 2001; Wang & Tuttle, 2009).
6
We note that there is a body of literature that examines the association between auditor tenure/rotation and perceived FRQ/AQ although this literature is not a direct focus of our literature review. This literature documents
mixed ndings, as well. For example, some studies nd that longer auditor tenure is associated with reduced perceived FRQ/AQ (Dao, Mishra, & Raghunandan, 2008; Kealey, Lee, & Stein, 2007), some studies do not nd such
a negative association (Ghosh & Moon, 2005; Mansi, Maxwell, & Miller, 2004), and other studies suggest a nonlinear relation (Boone, Khurana, & Raman, 2008). Furthermore, some studies nd that mandatory audit rm rotation enhances perceived FRQ/AQ (Jennings, Pany, & Reckers, 2006; Jeong, Jung, & Lee, 2005), whereas others
do not (e.g., Kaplan & Mauldin, 2008). Finally, Chi et al. (2009) document a weak association between mandatory
audit partner rotation and perceived FRQ/AQ.
7
We also conduct an analysis from the auditor tenure perspective. Based on our proxy for audit quality (i.e., the
auditor's likelihood to issue a modied audit opinion, MAO), we nd that MAOs are issued more often when audit rm tenure is shorter. However, several studies show that a company is more likely to switch its audit rm if its
auditor issues an MAO (Chow & Rice, 1982; Lennox, 2000), thus the negative association between audit rm tenure and audit quality could be due to self-selection. We cannot conclude that long audit rm tenure causes lower
audit quality because we cannot rule out the alternative explanation of opinion shopping. This makes it difcult
for us to draw a convincing inference from an analysis of tenure and therefore we focus on auditor rotation in
this study.
115
affiliation with the government was a major impediment to auditor independence. To help
auditors gain financial and operational independence, the CICPA and the MOF launched
the disaffiliation program in 1996 (Gul, Sami, & Zhou, 2009; Yang, Tang, Kilgore, &
Jiang, 2001). This program required all auditors to sever their links with their sponsoring
bodies. The CICPA and the MOF have also been engaged in establishing a new set of Independent Auditing Standards since 1995 (DeFond, Wong, & Li, 2000), which are highly
convergent with the International Standards on Auditing promulgated by the International
Federation of Accountants (Lin & Chan, 2000; Xiao, Zhang, & Xie, 2000).
Unlike the United States, China is one of the few markets around the world that requires
certified public accountants (normally two) to sign their names on audit reports. According
to the relevant Chinese regulation, in typical situations one of the two signing auditors
must serve as the lead auditor responsible for fieldwork, and the other must be at least a
deputy executive of the firm and serve as the reviewer. These two signing auditors are required to assume the same legal liabilities (unless one can prove the contrary). 8 An audit
report with the name of an individual auditor allows us to identify audit partner rotations
based on the annual reports. Unfortunately, we do not know which of the two signing partners the engagement partner is and which is the reviewing partner.
On October 8, 2003, the CSRC and the MOF jointly issued a policy requiring auditors
who sign the audit report of a listed company in China to be rotated off after five years.
Panel A of Table 1 summarizes the key requirements of the mandatory audit partner rotation policy, while Panel B summarizes the CSRC's official comments on the rationale behind the policy (which were made public immediately following the implementation of the
policy). This policy is aimed at addressing concerns about auditor independence and audit
quality due to the close relationship between audit partners and their listed clients. It enables us to identify mandatory audit partner rotations since 2003.
In some cases, audit firms have been banned from practicing because of regulatory
sanctions or liquidation in the Chinese audit market. For example, in 1998, two large Chinese audit firms (Chengdu Shudu CPAs and Sichuan CPAs) were suspended from practice
for three years because their listed clients committed financial frauds (Hongguang Industrial (Code 600083) and Dongfang Boiler Group (Code 600786), respectively). This situation
resulted in over 40 listed companies being forced to switch to new audit firms. In 2001,
another seven audit firms were terminated or suspended from practice due to their clients'
frauds or other regulatory violations, leading to more than 170 listed companies being
forced to switch to new audit firms (Chen et al., 2009). The State-owned Assets Supervision and Administration Commission of the State Council (SASAC) of China also required
mandatory audit firm rotations. In 2004, the SASAC mandated that each company on a list
of major Chinese state-owned enterprises (SOEs) rotates their audit firms with new firms.
This policy forced a few listed companies (as subsidiaries of their parent SOEs) to rotate
their audit firms. In 2005, the SASAC further required that each SOE under its jurisdiction
rotates its audit firm after serving as auditor for five consecutive years. 9
Taken together, we are able to identify five forms of auditor rotation in China: mandatory audit partner rotation, mandatory audit firm rotation, voluntary audit partner rotation,
8
9
In this study we refer to the signing auditor (rotation) as the audit partner (rotation).
We provide typical examples for mandatory audit rm rotation in China's listed companies in Appendix A.
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Table 1
Excerpted requirements for mandatory audit partner rotation in China.
Panel A: the key requirements regarding mandatory rotation of signing auditors for audits of listed companies as
mandated by the CSRC and the MOF of China on October 8, 2003
No. of article
Article contents
Article 3
Signing auditors must not provide audit services for the same entity for more than five
consecutive years, except under the circumstances specified in Article 7.
Signing auditors must not provide audit services for the same initial public offering
(IPO) entity for more than two consecutive years after the IPO.
If both of the signing auditors have provided audit services for the same entity for five
consecutive years during the same period, one of them is allowed to extend to a
maximum of one more year their position as a signing auditor of the entity concerned.
After a signing auditor is rotated off due to having provided audit services for the
same entity for five consecutive years, he should not provide audit services for this
entity within two years.
This regulation takes effect on January 1, 2004.
Article 5
Article 7
Article 8
Article 13
Panel B: the CSRC's ofcial comments on the rationales behind the mandatory audit partner rotation policy
Questions
Comments
What is the main reason for the mandatory

rotation of signing auditors?
A number of international and domestic corporate scandals

indicate that technical incompetence might not be the reason for
audit failure. Rather, extended audit tenure may impair auditor
independence Besides, long auditor tenure can also be
detrimental to the discovery of new problems. The rotation of
lead engagement partners can enhance auditor independence and
bring in a fresh perspective. Therefore, the new policy may lead
to improved audit quality and better protection of investors.
We are aware of this proposal. In terms of auditor independence,
audit firm rotation may be more thorough than audit partner
rotation. However, we have to balance the costs and benefits.
Mandatory audit firm rotation may improve auditor
independence. However, it could result in an increased
likelihood of audit failures due to the lack of client-specific
knowledge Besides, to our knowledge, most jurisdictions, regions, and organizations (e.g. the U.S., Hong Kong., and the International Federation of Accountants) do not mandate audit firm
rotation. Although some jurisdictions require the rotation of
audit firms, the results are far from ideal. Mandatory audit firm rotation may provide an excuse for the client to dismiss the auditor.
Some people argue that mandatory audit

partner rotation cannot address auditor
independence issues completely; instead,
they propose mandatory audit firm
rotation. What is the CSRC's view on
this proposal?
voluntary audit firm rotation, and no rotation. These unique institutional and disclosure
features provide us with a laboratory setting in which we can compare comprehensively
various forms of auditor rotation at different levels and in different settings.
2.4. Research questions
Based on our review of the literature, we cannot conclude yet whether mandatory auditfirm or audit-partner rotation can improve audit quality, nor are we clear on whether voluntary audit firm or partner rotation can substitute for mandatory audit rotations.
117
Mandatory rotations may enhance audit quality if we assume rotation brings a fresh perspective. However, mandatory rotations may be less effective if the newly rotated auditors
lack sufficient knowledge of the client. The loss of client-specific knowledge could potentially impair the effectiveness and quality of the audit. Voluntary rotation practices can be
effective in maintaining audit quality if an audit firm's market and economic incentives for
establishing or maintaining a good reputation exceed its economic gains derived from acquiescing to the demands of specific clients. Overall, it is unclear whether the mandatory
rotation of auditors is an effective method to enhance audit quality. The extent to which
voluntary and mandatory auditor rotations at different levels can substitute for each other
in maintaining audit quality is therefore an empirical question. The above discussion
leads to the following research question:
RQ1: Are auditor rotations at different levels (partner level vs. firm level) in different
settings (mandatory vs. voluntary) associated with enhanced audit quality?
An emerging literature examines how institutional factors affect audit quality across
countries (Choi & Wong, 2007; Francis & Wang, 2008; Francis et al., 2003; Khurana &
Raman, 2004). Institutions vary widely across China (e.g., Wang, Wong, & Xia, 2008),
which provides us with an opportunity to test whether institutional and market development factors, such as the legal environment and investor protection, affect audit quality.
An advantage of conducting inter-regional studies within one country is that we can capture the effect of institutions on audit quality free from contamination due to country differences in accounting and auditing standards, taxation, and bankruptcy laws. As prior
literature (e.g., Francis & Wang, 2008; Francis et al., 2003; Khurana & Raman, 2004) suggests, auditors may be more sensitive to the cost of client misreporting and are more likely
to maintain audit quality as institutional regimes become stronger. In regions with well
(less) developed markets, the auditors may be more (less) likely to be concerned about
the potential effect of compromising audit quality on their legal liability and market reputation. Thus, well-developed provinces have a lower incremental demand for mandatory
auditor rotation. In contrast, mandatory auditor rotation may be more important in less developed provinces, which lack market incentives or oversights to keep auditors diligent and
independent. Therefore, we examine whether the effect of mandatory or voluntary auditor
rotations on audit quality is more pronounced in less developed regions than in welldeveloped regions. This leads to our second research question:
RQ2: Are auditor rotations at different levels (partner level vs. firm level) and in different settings (mandatory vs. voluntary) associated with higher audit quality in less developed regions than in well-developed regions?
3. Research design
3.1. Identifying various forms of auditor rotations
In this section, we provide a detailed explanation of how we identify and distinguish
among various forms of auditor rotation in China's listed companies. First, we identify
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all audit firm changes by hand. If the audit firm in year t is not the same as the one in year
t 1, we identify a rotation of audit firm. 10 , 11 We classify an audit firm rotation as mandatory
if the preceding audit firm changes because of its inability to provide audit services for the
client. For example, as mentioned earlier, an audit firm may be sanctioned by the regulators
to suspend or cease practice; it may be required by a government agency (e.g., the
SASAC) to rotate off the client; or it may have self-liquidated. In cases where we are not
aware of any mandatory reason for an audit firm change, we classify them as voluntary
audit firm rotations.
When there is no change in audit firm in year t, we identify whether audit partner
rotation occurs in year t. Since two auditors normally sign the audit report in China,
if any one of the signing auditors changes in year t from year t 1, we define it as
an audit partner rotation. Prior to the 2003 mandatory audit partner rotation policy in
China, all identified audit partner rotations were defined as voluntary. Since the enactment of the policy, an audit partner rotation in year t is defined as mandatory if
the rotating-off auditor has reached the maximum number of audit tenure years in
year t 1. Otherwise, an audit partner rotation is classified as voluntary. In circumstances in which one of the two signing auditors rotates off in year t because s/he
meet the criterion for mandatory partner rotation, and the other auditor rotates off in
year t without serving the maximum number of years, we define the cases as mandatory audit partner rotations.
3.2. Empirical model
A modified audit opinion is an important manifestation of different audit outcomes
and audit quality (Francis, 2004) and generally receives a great deal of attention from
regulators, investors, and the public (Chen, Su, & Zhao, 2000; Chow & Rice, 1982;
Dopuch, Holthausen, & Leftwich, 1986). Thus, a modified audit opinion is widely
used as a proxy for audit quality, both in the auditing literature (e.g., Chow & Rice,
1982; Craswell, Stokes, & Laughton, 2002; Krishnan, 1994; Lennox, 2005) and in
China-related studies (Chan, Lin, & Mo, 2006; Chen, Chen, & Su, 2001; Chen et al.,
2010; DeFond et al., 2000; Wang et al., 2008). Following Chen et al. (2000, 2001),
Chen et al. (2010), and Wang et al. (2008), we classify unqualified opinions with an
explanatory paragraph, qualified opinions, disclaimers, and adverse opinions as modified opinions. 12 We run the following pooled multivariate logistic regression to analyze
We do not treat a simple change in an audit rm's name or an audit rm merger as a change in audit rm.
There could be instances in which a signing auditor has reached the upper limit (i.e., ve years) of her audit
tenure for a client in year t 1 under the requirement of mandatory audit partner rotation policy while the client
changes the audit rm in year t. We identify such a scenario as an audit rm rotation rather than a mandatory audit
partner rotation in year t.
12
Companies that receive an opinion that is qualied or one that is unqualied with an explanatory paragraph
are required to publish their audit reports in selected securities newspapers and to make lings with the CSRC.
Chinese auditors often employ unqualied opinions with explanatory paragraphs as an alternative to qualied
opinions to reduce the possibility of losing their clients (Chen et al., 2001). The CSRC also treats this type
of opinion in the same way as they treat a qualied opinion in terms of disclosure requirements. For detailed
discussions and examples of modied audit opinions, see DeFond et al. (2000), Chen et al. (2001), and Haw,
Park, Qi, and Wu (2003).
10
11
119
whether the likelihood of a firm receiving a modified opinion increases when auditor
rotation takes place. 13
Logit pMOD 1 b0 b1 MPR b2 MFR b3 VPR b4 VFR b5 LTA
b6 LEV b7 RECV b8 INV b9 OPI b10 LOSS
b11 PREMOD b12 SEO b13 BIG4 b14 CTRGOV
b15 LOCGOV b16 AGE IndDum YrDum
ProvDum ;
where
Dependent variable
MOD a dummy variable equal to 1 if a firm receives a modified audit opinion, and
0 otherwise.
Experimental variables
MPR
a dummy variable equal to 1 if it is a mandatory audit partner
0 otherwise.
MFR
a dummy variable equal to 1 if it is a mandatory audit firm
0 otherwise.
VPR
a dummy variable equal to 1 if it is a voluntary audit partner
0 otherwise.
VFR
a dummy variable equal to 1 if it is a voluntary audit firm
0 otherwise.
rotation, and
rotation, and
rotation, and
rotation, and
Control variables
LTA
natural logarithm of total assets in ten thousand RMB Yuan.
LEV
total liabilities to total assets ratio.
RECV receivables to total assets ratio.
INV
inventory to total assets ratio.
OPI
(income from operations profit from other operations) / total assets.
LOSS a dummy variable equal to 1 if a firm reports a net loss in year t, and 0 otherwise.
PREMOD a dummy variable equal to 1 if a firm receives a modified audit opinion in year
t 1, and 0 otherwise.
SEO
a dummy variable equal to 1 if a firm raises additional capital in year t + 1, and
0 otherwise.
BIG4 a dummy variable equal to 1 if the auditor is from a Big 4 audit firm, and
0 otherwise.
CTRGOV a dummy variable equal to 1 if the ultimate controlling shareholder is at the central government level (i.e., the SASAC), another central governmental agency, or
a central-level SOE, and 0 otherwise.
13
For brevity, we do not include subscripts i and t to denote rm and year.
120
LOCGOV a dummy variable equal to 1 if the ultimate controlling shareholder is at the

local government level (i.e., the SASAC local branch), another local government,
or a local SOE, and 0 otherwise.
AGE
the number of years since the initial public offering (IPO).
IndDum industry dummies for 12 broad industries (excluding the financial sector) based
on the first digit of the CSRC industry classification.
YrDum year dummies for the 9 fiscal years in our sample period of 19972005.
ProvDum province dummies for the 31 provincial jurisdictions in China Mainland.
The base group in model (1) includes observations with no audit partner rotation or
audit firm rotation relative to the previous period audit. As discussed in Section 2.4, we
do not predict the sign for various forms of auditor rotation. Auditor rotation could have
both positive and negative effects on audit quality. We are empirically interested in whether the effect of increased independence dominates that of start-up costs.
We include the control variables based on their use in related studies (Chen et al., 2001;
Craswell et al., 2002; DeFond et al., 2000; Krishnan, 1994) and that capture the unique institutional characteristics of China. Client size (LTA) is expected to be negatively associated
with the frequency of receiving modified audit opinions because larger companies tend to
be financially healthier. We use the total liabilities to total assets ratio (LEV), receivables
to total assets ratio (RECV), 14 and inventory to total assets ratio (INV) as the proxies for financial conditions and risks. We expect that these variables are positively associated with
the frequency of receiving modified audit opinions. A more profitable company is less likely to be in financial distress and/or engage in questionable accounting practices, so we expect the variable OPI (= (income from operations profit from other operations) / total
assets) 15 to have a negative coefficient and the variable LOSS to have a positive coefficient.
Following Monroe and Teh (1993), we include a dichotomous variable, PREMOD, to
control for the effect of receiving a modified audit opinion in the previous year. Prior studies show that the Big N audit firms provide a higher quality of audit service than the nonBig N audit firms (e.g., Johnson & Lys, 1990). We expect BIG4 auditors to be more likely
to issue modified audit opinions.
The regulations in China stipulate that listed companies must meet a target profitability
level to raise additional capital through a rights offering (Chen & Yuan, 2004; Haw, Qi,
Wu, & Wu, 2005). As a result, companies with an ex post recent seasoned equity offering
(SEO) generally have a profitable profile. The firms with SEOs are less likely to receive a
modified audit opinion. Another institutional characteristic of Chinese stock markets is that
government-related entities control many listed companies. Most listed companies are
14
In addition to including accounts receivable, we also include Other Receivables to calculate the ratio. Other
receivables include receivables due from the controlling shareholder and these can be very large. In some cases
Other receivables are long overdue and may form a type of expropriation by the controlling shareholder.
15
We use the earnings item terms that are used by Haw et al. (2005, Appendix 1). We classify Prot from other
operations as non-recurring because this item is widely used to recognize prots from non-recurring transactions
that are sometimes the result of earnings management or resource expropriation activities. Therefore, OPI measures income from core operations.
121
business units that have been carved out of SOEs by a central or local government agency.
This agency then serves as the parent holding company of that listed company. Given that
government-controlled companies are more likely to be economically and/or politically
protected by central or local governments from business risks and operating uncertainties,
auditors may be less likely to issue modified audit opinions to these clients (Chan et al.,
2006; Wang et al., 2008). We include two ultimate controlling shareholder dummies,
CTRGOV and LOCGOV, in our model. 16 CTRGOV (LOCGOV) is coded one when the
central government (local government) or an agency of the central government (local government) is the major stockholder in a firm. We expect the coefficients for CTRGOV and
LOCGOV to be negative.
Prior China-related studies suggest that older clients are more likely to have exhausted
the capital raised from their IPOs and are therefore more susceptible to financial distress
(Chen et al., 2001; DeFond et al., 2000). Therefore, we include the variable AGE to control
for the listing age of a company and expect the coefficient on AGE to be positive. Finally, we
include industry dummies (based on the CSRC classification), year dummies, and province
dummies to control for the fixed effects of industry, fiscal year, and provincial jurisdictions.
Although our study examines the effect of market and legal institutional developments within a single country many regional differences exist among Chinese provinces. Adding province dummy variables helps control for the potentially omitted regional differences.
3.3. Market development level

Audit quality can vary with institutional and market development factors such as the
legal environment and investor protection (Choi & Wong, 2007; Francis & Wang, 2008;
Francis et al., 2003; Khurana & Raman, 2004). Researchers commonly observe that the development of the Chinese market and legal environment is still inchoate (Allen, Qian, &
Qian, 2005). One important feature of the Chinese economy is that decentralization has
led to great heterogeneity across regions in terms of market development level and institutional qualities. 17
To examine whether the effects of various forms of auditor rotation (especially mandatory arrangements) vary across different market environments, we make use of an index of
market intermediaries and legal environment that prior studies have used (e.g., Wang et al.,
2008). The index is compiled by China's National Economic Research Institute (NERI),
with the first edition in 2001 and updates in 2003, 2004, 2007, and 2010. It has a development score for each province and major municipality and includes a number of sub-indices
measuring the percentages of lawyers and certified public accountants in the total
16
In addition to the two categories of ultimate controlling shareholder (CTRGOV and LOCGOV), a third category (as a benchmark) includes individual investors, employee collective shareholdings, universities, and other nonSOE entities.
17
The market development level in eastern and coastal areas is much more advanced than in central and western
provinces (Fan & Wang, 2001). For example, in terms of the percentage of lawyers (certied public accountants)
in the whole population, the national average level is 9.3 (4.8) per thousand people, ranging from 32 (18) in Beijing, to 2 (1) in Guizhou province.
122
population, market order, lawsuit enforcement efficiency, intellectual property rights protection and consumer rights protection.
We partition the full sample into two sub-samples (i.e., companies located in regions
with strong versus weak legal institutions). For each year during our sample period, we
classify a province with above-median (below-median) index of market intermediaries
and legal environment as a region with strong (weak) legal institutions. We run regressions
using both the full sample and the two subsamples. This approach allows the control variables of the audit opinion model to vary across the well developed and less developed regions. Based on our development of the research questions, we expect that the rotationrelated experimental variables in the less developed subsample will be more positive
than in the well-developed subsample.
4. Sample
4.1. Sample selection
The initial sample of 9761 Chinese main-board A-share firm-year observations from
1997 to 2005 was collected from the China Stock Market Accounting Research
(CSMAR) database. We start from 1997 because that year is when the market development index became available (Fan, Wang, & Zhu, 2010). We use the name of the audit
firm/signing auditors that appears in the first post-IPO year audit report as a preliminary
basis for identifying the subsequent year's firm-level/partner-level rotation status. To
identify the subsequent year's rotation status, we then compare the audit firm/signing auditor name with the firm and signing partner name of the prior year. We exclude 828
first post-IPO year observations during the sample period, as they do not have prior
year auditor information for an annual audit. We delete another 322 observations for
which we cannot identify the audit partner rotation status. 18 Finally, we exclude 51 financial industry observations. The sample selection process yields a final sample of
8560 firm-year observations.
4.2. Sample composition
Table 2 lists the sample distribution by the form of auditor rotation. Table 2 shows that
there have been 568 mandatory audit partner rotation cases since the 2003 regulation that
required partner rotation. We identify 276 mandatory audit firm rotations, of which 215
were mandatory because of the termination of the former audit firms due to significant
audit failures or other violations, 33 because of the liquidation of the former audit firms,
The nondisclosure of the names of the signing auditors in a particular rm year normally leads to a failure in
identifying the audit partner rotation status for both the current and subsequent rm year unless there is an audit
rm switch in the subsequent year. For those post-2001 observations in which the names of the signing auditors
were not disclosed, we obtain most of the missing names from the CICPA. The CICPA has required Chinese audit
rms with securities market licenses to le with them basic information about listed companies' annual audits
since early 2002.
18
123
Table 2
Sample composition by the form of auditor rotation.
Year
1997
1998
1999
2000
2001
2002
2003
2004
2005
19972005
Mandatory rotation
Voluntary rotation
Audit partner
rotation
Audit partner
rotation
Audit partner
rotation
Audit partner
rotation
(MPR)
(MFR)
(VPR)
(VFR)
0
0
0
0
0
0
163
245
160
568
(6.6%)
0
47
0
11
168
0
0
13
37
276
(3.2%)
320
352
434
414
474
482
363
496
535
3870
(45.2%)
21
34
50
78
74
101
86
92
99
635
(7.4%)
No form
of auditor
rotation
Total
123
212
245
342
311
544
580
401
453
3211
(37.5%)
464
645
729
845
1027
1127
1192
1247
1284
8560
(100%)
Note: The percentage of observations within each form of auditor rotation to the total number of observations is
provided in parentheses.
and 28 because of the SASAC's requirement for a new audit firm. There are 3870 (45.2%)
voluntary audit partner rotation observations. As for voluntary audit firm rotation, we have
identified 635 observations. Finally, there are 3211 (37.5%) observations without any form
of auditor rotation, which serves as the base group for subsequent analyses.
4.3. Descriptive statistics
Table 3 summarizes the descriptive statistics including the raw values of the main variables that are used in model (1), in the full sample, in the strong legal institutions subsample,
and in the weak legal institutions subsample, respectively. For the full sample, modified
audit opinions are issued to about 14.6% of the sample observations. Central or local government (including their agencies and SOEs under their control) controls 17.8% and 52.8%
of sample companies, respectively. 7.7% of sample companies make seasoned equity offerings and 14.3% suffer a net loss. Big 4 international accounting firms audit only 6.3% of the
sample companies, which is very different from the audit market structure of the more developed capital markets (such as the U.S., Australia, or Taiwan). Most of the continuous
control variables have an approximately symmetric distribution. Additional comparisons
between the strong and weak legal institutions subsamples reveal that companies located
in regions with strong legal institutions are larger in size, higher leveraged, less profitable,
more often controlled by central government, and have a longer listing history. To mitigate
the impact of extreme outliers, we winsorize all of the continuous variables at either the 1st
or 99th percentiles in the subsequent regression analyses. 19
19
When we use raw values for all continuous variables in the models, the results for all experimental variables
remain qualitatively unchanged.
124
Table 3
Descriptive statistics of model variables.
Variable
Full sample
Strong legal institution

subsample
(N = 8560)
MOD
MPR
MFR
VPR
VFR
LTA
LEV
RECV
INV
OPI
LOSS
PREMOD
SEO
BIG4
CTRGOV
LOCGOV
AGE
(N = 6005)
Weak legal institution

subsample
(N = 2555)
Mean
Median
Mean
Median
Mean
Median
0.146
0.066
0.032
0.452
0.074
11.799
0.525
0.180
0.150
0.012
0.143
0.133
0.077
0.063
0.178
0.528
5.679
0
0
0
0
0
11.729
0.476
0.148
0.120
0.030
0
0
0
0
0
1
5.385
0.158***
0.070**
0.026***
0.439***
0.081***
11.878***
0.545***
0.179
0.155***
0.008***
0.141
0.149***
0.073*
0.074***
0.200***
0.505***
6.032***
0***
0*
0***
0***
0***
11.818***
0.485***
0.145**
0.120**
0.028***
0
0***
0*
0***
0***
1***
5.729***
0.119
0.058
0.047
0.483
0.058
11.613
0.479
0.183
0.139
0.022
0.148
0.097
0.085
0.037
0.137
0.582
4.850
0
0
0
0
0
11.556
0.455
0.153
0.119
0.034
0
0
0
0
0
1
4.526
For each year during our sample period, we classify a province with an above-median (below-median) index of
market intermediaries and legal environment as a region with strong (weak) legal institutions.
***, **, and * represent the 0.01, 0.05, and 0.10 significance levels (two-tailed), respectively, based on t- or
MannWhitney test between strong and weak legal institution subsamples.
Variable definitions:
MOD = a dummy variable equal to 1 if a firm receives a modified audit opinion, and 0 otherwise.
MPR = a dummy variable equal to 1 if it is a mandatory audit partner rotation, and 0 otherwise.
MFR = a dummy variable equal to 1 if it is a mandatory audit firm rotation, and 0 otherwise.
VPR = a dummy variable equal to 1 if it is a voluntary audit partner rotation, and 0 otherwise.
VFR = a dummy variable equal to 1 if it is a voluntary audit firm rotation, and 0 otherwise.
LTA = natural logarithm of total assets in ten thousand RMB Yuan.
LEV = total liabilities to total assets ratio.
RECV = receivables to total assets ratio.
INV = inventory to total assets ratio.
OPI = (income from operations profit from other operations) / total assets.
LOSS = a dummy variable equal to 1 if a firm reports a net loss in year t, and 0 otherwise.
PREMOD = a dummy variable equal to 1 if a firm receives a modified audit opinion in year t 1, and 0 otherwise.
SEO = a dummy variable equal to 1 if a firm raises additional capital in year t + 1, and 0 otherwise.
BIG4 = a dummy variable equal to 1 if the auditor is from a Big 4 audit firm, and 0 otherwise.
CTRGOV = a dummy variable equal to 1 if the ultimate controlling shareholder is at the central government level
(i.e., the SASAC), another central governmental agency, or a central-level SOE, and 0 otherwise.
LOCGOV = a dummy variable equal to 1 if the ultimate controlling shareholder is at the local government level
(i.e., the SASAC local branch), another local government, or a local SOE, and 0 otherwise.
AGE = the number of years since the initial public offering (IPO).
Table 4 presents the Pearson correlations among the variables in model (1) for the full
sample. Among the four auditor rotation variables, only voluntary audit firm rotation is
positively correlated with modified audit opinion. In contrast, mandatory audit partner
125
rotation and voluntary audit partner rotation are negatively associated with modified audit
opinion. We find no significant correlation between mandatory audit firm rotation and
modified audit opinion. However, as we do not control for other factors that might have
an effect on issuing a modified audit opinion, we cannot draw strong inferences from the
correlation table as regards to the effect of various forms of auditor rotation on audit quality. Table 4 also indicates that most correlations among independent variables have an absolute coefficient of less than 0.5. The correlation coefficients that exceed or approach 0.5
are 0.70 (OPI and LOSS), 0.57 (LEV and OPI), and 0.49 (CTRGOV and LOCGOV).
Therefore, multicollinearity does not pose a serious threat to our models. 20
5. Main results of logistic regression analyses
Table 5 presents the results of model (1) testing the auditor rotation effects. Column 1
reports the results for the full sample, whereas columns 2 and 3 report results for the strong
and weak legal institution subsamples, respectively. The model chi-squares of all regressions are significant (p b 0.001). The regression results for the full sample do not indicate
significant coefficients for mandatory audit partner rotation, mandatory audit firm rotation,
or voluntary audit partner rotation. However, the coefficient on VFR is positive at a marginally significant level (p = 0.057), which suggests that voluntary audit firm rotation is associated with increased auditor reporting conservatism.
When we partition the full sample into two subsamples based on the median level of legal
institution development, column 2 of Table 5 (the strong legal institution sample) indicates that
none of the coefficients on the four auditor rotation variables are significantly different from
zero. In contrast, column 3 of Table 5 (the weak legal institution sample) shows that the coefficients on MPR and VFR are significantly positive (p = 0.009 and 0.093, respectively). This
correlation suggests that in regions with weak legal institutions, mandatory partner rotation
and voluntary audit firm rotation are associated with increased auditor reporting conservatism.
Further tests of differences between the coefficients for the strong and weak legal institution subsamples show that there is a significant difference in the coefficient on MPR (Chisquare = 9.61, p = 0.002). This result suggests that in regions with weak legal institutions,
mandatory audit partner rotation can be more effective in improving audit quality than in
regions with strong legal institutions, possibly because auditors are less self-disciplined in
a weak legal environment. However, other forms of auditor rotation do not enhance audit
quality for clients located in regions with weak institutional development compared with
those in regions with strong institutional development. The results also suggest that the
positive effect of voluntary audit firm rotation on auditor reporting conservatism in regions
with weak legal institutions is much weaker than the effect of mandatory audit partner
rotation.
Regarding the results for the control variables, the coefficients for financial leverage
(LEV), the receivables to total assets ratio (RECV), loss status (LOSS), and the prior-
20
This is further veried by collinearity tests. The highest variance ination factor of any variable in model (1) is
2.8.
126
MPR
MFR
VPR
VFR
LTA
LEV
RECV
INV
OPI
LOSS
PREMOD
SEO
MOD
MPR
MFR
VPR
VFR
LTA
LEV
RECV
INV
OPI
LOSS
PREMOD
0.05
(0.00)
0.00
(0.77)
0.03
(0.00)
0.12
(0.00)
0.18
(0.00)
0.38
(0.00)
0.35
(0.00)
0.05
(0.00)
0.47
(0.00)
0.43
(0.00)
0.51
(0.00)
0.09
(0.00)
0.05
(0.00)
0.24
(0.00)
0.08
(0.00)
0.09
(0.00)
0.01
(0.46)
0.09
(0.00)
0.01
(0.34)
0.03
(0.01)
0.02
(0.03)
0.07
(0.00)
0.04
(0.00)
0.17
(0.00)
0.05
(0.00)
0.02
(0.13)
0.00
(0.72)
0.01
(0.28)
0.01
(0.49)
0.01
(0.39)
0.00
(0.93)
0.02
(0.07)
0.01
(0.46)
0.26
(0.00)
0.05
(0.00)
0.06
(0.00)
0.02
(0.06)
0.01
(0.40)
0.05
(0.00)
0.03
(0.01)
0.03
(0.00)
0.05
(0.00)
0.05
(0.00)
0.08
(0.00)
0.06
(0.00)
0.02
(0.14)
0.12
(0.00)
0.08
(0.00)
0.16
(0.00)
0.04
(0.00)
0.03
(0.01)
0.30
(0.00)
0.07
(0.00)
0.24
(0.00)
0.17
(0.00)
0.19
(0.00)
0.03
(0.00)
0.25
(0.00)
0.15
(0.00)
0.57
(0.00)
0.38
(0.00)
0.35
(0.00)
0.06
(0.00)
0.07
(0.00)
0.34
(0.00)
0.27
(0.00)
0.27
(0.00)
0.00
(1.00)
0.01
(0.61)
0.02
(0.04)
0.04
(0.00)
0.02
(0.17)
0.70
(0.00)
0.36
(0.00)
0.19
(0.00)
0.27
(0.00)
0.11
(0.00)
0.07
(0.00)
SEO
BIG4
CTRGOV
LOCGOV
Table 4
Pearson correlation matrix for model variables for the full sample (N = 8560).
BIG4
CTRGOV
LOCGOV
0.02
(0.07)
0.01
(0.58)
0.00
(0.65)
0.11
(0.00)
0.01
(0.55)
0.04
(0.00)
0.02
(0.02)
0.03
(0.00)
0.03
(0.01)
0.02
(0.09)
0.03
(0.02)
0.10
(0.00)
0.01
(0.24)
0.01
(0.52)
0.05
(0.00)
0.04
(0.00)
0.28
(0.00)
0.10
(0.00)
0.16
(0.00)
0.12
(0.00)
0.08
(0.00)
0.05
(0.00)
0.05
(0.00)
0.26
(0.00)
0.14
(0.00)
0.01
(0.33)
0.10
(0.00)
0.05
(0.00)
0.01
(0.30)
0.00
(0.83)
0.00
(0.72)
0.10
(0.00)
0.07
(0.00)
0.06
(0.00)
0.06
(0.00)
0.22
(0.00)
0.05
(0.00)
0.02
(0.12)
0.08
(0.00)
0.14
(0.00)
0.05
(0.00)
0.04
(0.00)
0.06
(0.00)
0.10
(0.00)
0.03
(0.01)
0.01
(0.57)
0.03
(0.00)
0.19
(0.00)
0.13
(0.00)
0.04
(0.00)
0.06
(0.00)
0.49
(0.00)
0.02
(0.07)
0.00
(0.90)
Two-tailed p-values are reported in parentheses.

CTRGOV = a dummy variable equal to 1 if the ultimate controlling shareholder is at the central government level (i.e., the SASAC), another central governmental agency,
or a central-level SOE, and 0 otherwise.
LOCGOV = a dummy variable equal to 1 if the ultimate controlling shareholder is at the local government level (i.e., the SASAC local branch), another local government,
or a local SOE, and 0 otherwise.
AGE
0.05
(0.00)
0.05
(0.00)
0.07
(0.00)
0.07
(0.00)
127
128
year modified audit opinion (PREMOD) are significantly positive (p b 0.01) across all regressions, and the coefficient for the operating profitability (OPI) is significantly negative
(p b 0.01). These findings suggest a close association between auditor opinion and client
financial risk, which is consistent with the findings of prior studies (e.g., Craswell et al.,
2002; DeFond et al., 2000; Krishnan, 1994). 21 The seasoned equity offering dummy variable SEO is negatively associated with the likelihood of receiving a modified audit opinion (p b 0.01) in two out of the three regressions. The coefficients for CTRGOV and
LOCGOV are significantly negative in all of the regressions (with p b 0.10 or better).
These statistics suggest that Chinese listed companies controlled by central government
or SOEs are less likely to receive a modified audit opinion. The coefficient for BIG4
is positive and significant in the weak legal institution subsample, indicating that Big 4
auditors issue audit reports more conservatively in regions with weak legal institutions.
The ownership (CTRGOV, LOCGOV) and BIG4 results are similar to those reported
by Wang et al. (2008). In general, the results for the control variables are broadly consistent with those reported in previous studies.
6. Sensitivity and additional analyses
We run a battery of sensitivity and additional analyses to check the robustness of our
key findings. All of the following sensitivity tests and additional analyses consistently suggest that mandatory audit partner rotations have a positive effect on audit quality in regions
with weak legal institutions (p b 0.01 or 0.05). Furthermore, this positive effect is significantly greater than it is in regions with strong legal institutions (p b 0.01 or 0.05). 22
6.1. Interactions between auditor rotations and institutional development
Instead of running model (1) based on partitioned subsamples, we add the legal institutional development dummy variable (WEAKMKT, coded 1 for less developed regions and
0 for well developed regions) and its interaction items with the four auditor rotation variables (MPR, MFR, VPR, and VFR) in model (1) for the full sample (N = 8560). We find
that out of the four interaction items, only the coefficient on MPR*WEAKMKT is positive
and significant (p = 0.002). This alternative model specification corroborates the main results in Table 5.
21
One exception is the inventory to total assets ratio (INV), which has a signicantly negative coefcient. This
nding is inconsistent with prior studies based on U.S. or Australian data, but consistent with prior China-based
studies (e.g., Wang et al., 2008). In our sample, INV is negatively correlated with RECV (p b 0.01). However, in
previous studies (e.g. Craswell et al., 2002), the inventory ratio is positively correlated with the receivables ratio.
Therefore, inventory to assets ratio may be less associated with audit risk in China (Wang et al., 2008).
22
The sensitivity tests also suggest that voluntary audit rm rotation has a much weaker (positive) effect on an
auditor's reporting conservatism in regions with weak legal institutions (p b 0.10), and there is no statistical difference between its effect on weak legal institutions versus its effect on strong legal institutions. As for the other two
forms of auditor rotations (i.e., mandatory audit rm rotation and voluntary audit partner rotation), we nd no evidence that they have a signicant effect on MAO in either subsample, neither do we nd that their effect on MAO
is signicantly different under different market institutions.
129
6.2. Alternative approach to partitioning the sample

We use an alternative method to partition our sample. Specifically, we define the provinces that rank among the top (bottom) 10 of the legal development index as regions with
strong (weak) legal institutions. This classification results in a smaller sample size, but
makes the comparison between strong and weak legal institutions more distinct. The
main results (untabulated) are qualitatively unchanged.
6.3. Alternative base group of no-rotation observations
Given that the auditor rotation initiatives are largely driven by the concern about long
auditorclient relationships, we also use as the base group no-rotation observations with
an above-median length of audit firm tenure. 23 This reduces the size of the full sample
(N = 6945) and subsamples (N = 4903 and 2042 for strong and weak legal institution subsamples, respectively). The main results (untabulated) are qualitatively unchanged.
6.4. Additional control variables
Prior studies (e.g., DeFond, Raghunandan, & Subramanyam, 2002; Dopuch,
Holthausem, & Leftwich, 1987) suggest that stock market variables also affect audit opinions. To control for potentially omitted correlated variables, we follow prior studies and include three market-based variables in model (1). They are RETURN (the company's stock
return over the fiscal year), VOLATILITY (the variance of the residual from the market
model over the fiscal year), and BETA (the company's beta estimate using a market
model over the fiscal year). After adding these three variables to the model, we find all
the main results (untabulated) are qualitatively similar to those reported in Table 5. 24
6.5. Excluding all post-2003 voluntary audit partner rotations
The mandatory audit partner rotation policy was implemented in 2003. To circumvent a
two-year cooling-off period, some audit firms may adopt a strategy of rotating audit partners earlier, before reaching the five-year threshold. Based on our statistics (untabulated),
18.5% and 10.4% of the pre-2003 voluntary audit partner rotations occurred when the
prior-year audit partner (who has a longer tenure) had provided audit services for a client
for three and four years, respectively. However, among post-2003 voluntary audit partner
rotations, these proportions significantly increase to 22.6% (Chi-square = 8.43, p = 0.004)
and 18.1% (Chi-square = 42.23, p = 0.000), respectively.
Although the early rotation strategy itself is ostensibly voluntary, we are unsure if such
strategic partner rotations are truly voluntary. 25 Because we are not able to distinguish
In our full sample, the median length of audit rm tenure is four years. Therefore, in this sensitivity test we use
no-rotation observations with audit rm tenure no shorter than ve years as the base group.
24
As to the additional stock market variables, RETURN (VOLATILITY) is signicantly negative (positive) at the
1% level, whereas BETA is not signicant. These results suggest that, consistent with prior studies, lower market
return and higher market volatility are associated with a higher likelihood of receiving a modied audit opinion.
25
We appreciate an anonymous reviewer's suggestion that we include this additional analysis.
23
130
between truly voluntary and strategic partner rotations, we exclude all post-2003 voluntary
audit partner rotations in this sensitivity test. VPR is coded as 1 only for those retaining pre2003 voluntary audit partner rotations. Untabulated results show that our main findings remain qualitatively unchanged.
6.6. Excluding all pre-2003 observations
Given that there are no mandatory audit partner rotations prior to 2003, it may be argued
that it is difficult to compare various forms of auditor rotations over the full-sample period.
To address this concern, we exclude all pre-2003 observations in the full sample from our
analysis. The main results (untabulated) are qualitatively unchanged.
6.7. Further differentiating mandatory audit firm rotations
We include several sub-groups of mandatory audit firm rotations in our sample. Two
sub-groups are rotations due to the cessation of former audit firms. The first includes
215 cases that are similar to the widely-tested setting of the collapse of Arthur Andersen
in the United States, and the second includes 33 cases resulting from the liquidation of former audit firms. A third sub-group includes cases affected by the required rotation of an
audit firm by the SASAC (N = 28). Because of the difference in nature between the first
sub-group and the latter two sub-groups, and the small number of observations in the latter
two sub-groups, we delete those 61 cases (33 + 28) in this sensitivity test, and rerun model
Notes to Table 5:
Two-tailed p-values are reported based on standard errors adjusted for clustering on companies.
The model includes untabulated year-fixed, industry-fixed, and province-fixed effects.
CTRGOV = a dummy variable equal to 1 if the ultimate controlling shareholder is at the central government level
(i.e., the SASAC), another central governmental agency, or a central-level SOE, and 0 otherwise.
LOCGOV = a dummy variable equal to 1 if the ultimate controlling shareholder is at the local government level
(i.e., the SASAC local branch), another local government, or a local SOE, and 0 otherwise.
131
Table 5
Logistic regression results for the auditor rotation effect.
Dependent
variable:
MOD
Expected
sign
Column 1
Column 2
Column 3
Full sample
Strong legal institution

subsample
Weak legal institution

subsample
Coefcient
p-Value
Coefcient
p-Value
Coefcient
p-Value
Experimental variables
MPR
+/
MFR
+/
VPR
+/
VFR
+/
0.001
0.195
0.142
0.282
0.994
0.441
0.140
0.057
0.443
0.109
0.187
0.200
0.136
0.735
0.110
0.241
0.871
0.198
0.001
0.568
0.009
0.682
0.995
0.093
Control variables
LTA
LEV
+
RECV
+
INV
+
OPI
LOSS
+
PREMOD
+
SEO
BIG4
+
CTRGOV
LOCGOV
AGE
+
Constant
?
Model chi-square
(p-Value)
Pseudo R2
n
0.022
1.790
3.035
1.301
6.662
1.100
2.140
1.079
0.112
0.493
0.209
0.002
5.259
1647.67
(0.000)
0.430
8560
0.686
0.000
0.000
0.004
0.000
0.000
0.000
0.000
0.623
0.000
0.042
0.931
0.000
0.080
1.709
3.417
1.269
6.450
1.164
2.269
1.341
0.032
0.485
0.204
0.000
5.469
1192.46
(0.000)
0.450
6005
0.210
0.000
0.000
0.016
0.000
0.000
0.000
0.000
0.908
0.003
0.099
0.999
0.000
0.130
1.914
1.944
1.591
7.395
1.014
1.780
0.446
0.708
0.489
0.316
0.014
1.352
575.60
(0.000)
0.391
2555
0.284
0.000
0.001
0.084
0.000
0.001
0.000
0.260
0.035
0.062
0.077
0.729
0.378
Diff. in coeff. (strong vs. weak legal institutions)
Chi-square
p-Value
MPR
MFR
VPR
VFR
9.61
0.02
0.70
0.83
0.002
0.881
0.403
0.361
(1). Untabulated results show that the variables of interest remain unaffected (and MFR is
still non-significant in both the full sample and in the two subsamples). 26
6.8. Excluding all voluntary audit firm rotations
Previous studies find that companies with prior-year modified audit opinions or higher
levels of financial risk are more inclined to voluntarily change their auditors (e.g., Chow &
In a related sensitivity test, we replace MFR with MFR1 (coded 1 for 215 mandatory rm rotations due to regulatory sanctions) and MFR2 (coded 1 for the other 61 mandatory rm rotations) and rerun model (1), both for the
full sample and the two subsamples. We do not nd any signicant results for MFR1 or MFR2. Additionally, we
nd no statistical difference in the coefcients on MFR1 and MFR2 in each of the regressions.
26
132
Rice, 1982; Lennox, 2000; Schwartz & Menon, 1985). Our results may be affected by voluntary firm rotation selection bias. To rule out this possibility, we remove all voluntary
firm rotation observations and rerun regression model (1). The results for all of the other
auditor rotation variables remain qualitatively the same as those shown in Table 5.
6.9. Further differentiating mandatory audit partner rotations
As a final sensitivity test, we partition the audit partner rotations into partial rotation
(where only one of the two signing auditors is rotated off in a particular year) and complete rotation (where both of the two signing auditors are rotated off at the same time) in
both the voluntary and mandatory settings. Given that two auditors normally sign the
audit report, we may obtain additional insights by examining how partial partnerrotations and complete partner-rotations affect audit quality. A partial partner-rotation introduces one new auditor with a fresh perspective while maintaining the auditor who has
accumulated knowledge on the client. A complete partner-rotation involves a complete
disconnection between rotated-off auditors and the client, but with a higher start-up
cost for developing knowledge about the client. It is an empirical question whether a partial partner-rotation (either mandatory (MPRpartial) or voluntary (VPRpartial)) and a complete partner-rotation (either mandatory (MPRcomplete) or voluntary (VPRcomplete)) can
improve audit quality, and which is more effective.
Panel A of Table 6 presents the distribution of partial and complete partner-rotations of
a mandatory or voluntary nature. It shows that 75% of mandatory partner rotations and
79.7% of voluntary partner rotations are partial partner-rotations. We replace MPR and
VPR with MPRpartial, MPRcomplete, VPRpartial, and VPRcomplete in model (1) and rerun the
regressions. Panel B of Table 6 shows that the coefficient on MPRpartial is significantly
positive in the weak legal institution subsample (p = 0.012), and the difference between
the coefficients on MPRpartial for strong and weak legal institution subsamples is significant (p = 0.008). The coefficient on MPRcomplete is positive and only marginally significant
in the weak legal institution subsample (one-tailed p-value = 0.073). However, the differNotes to Table 6:
Two-tailed p-values are reported based on standard errors adjusted for clustering on companies.
The model includes untabulated control variables and year-fixed, industry-fixed, and province-fixed effects.
MPRpartial = a dummy variable equal to 1 if it is a mandatory audit partner rotation and only one of the two signing
auditors is rotated off, and 0 otherwise.
MPRcomplete a dummy variable equal to 1 if it is a mandatory audit partner rotation and both of the two signing
auditors are rotated off at the same time, and 0 otherwise.
VPRpartial = a dummy variable equal to 1 if it is a voluntary audit partner rotation and only one of the two signing
auditors is rotated off, and 0 otherwise.
VPRcomplete = a dummy variable equal to 1 if it is a voluntary audit partner rotation and both of the two signing
auditors are rotated off at the same time, and 0 otherwise.
For the definition of control variables, see Table 5.
133
ence between the coefficients on MPRcomplete for the strong and weak legal institution subsamples is statistically significant (p = 0.039). For partial and complete voluntary partner
rotations, we do not find a significant difference in their effect on audit quality between
the strong and weak legal institution subsamples. The results show that partial mandatory
Table 6
Partitioning of audit partner rotation into partial rotation and complete rotation.
Panel A: distribution of partial and complete audit partner rotations
Year
1997
1998
1999
2000
2001
2002
2003
2004
2005
19972005
Mandatory audit partner rotation
Voluntary audit partner rotation
(N = 568)
(N = 3870)
Partial rotation
Complete rotation
Partial rotation
Complete rotation
(MPRpartial)
(MPRcomplete)
(VPRpartial)
(VPRcomplete)
0
0
0
0
0
0
128
176
122
426
(75.0%)
0
0
0
0
0
0
35
69
38
142
(25.0%)
245
265
352
335
369
378
315
402
423
3084
(79.7%)
75
87
82
79
105
104
48
94
112
786
(20.3%)
Panel B: logistic regression results

Dependent
variable: MOD
Column 1
Column 2
Column 3
Full sample
Strong legal
institution subsample
Weak legal
institution subsample
Coefficient
p-Value
Coefficient
p-Value
Coefficient
p-Value
0.049
0.140
0.195
0.149
0.115
0.282
Yes
0.430
8560
0.846
0.692
0.442
0.136
0.492
0.058
0.344
0.798
0.108
0.201
0.125
0.200
Yes
0.450
6005
0.308
0.153
0.737
0.091
0.565
0.242
0.943
0.724
0.199
0.004
0.016
0.568
Yes
0.391
2555
0.012
0.146
0.682
0.983
0.955
0.093
Diff. in coeff. (Strong vs. weak legal institutions)
Chi-square
p-Value
MPRpartial
MPRcomplete
MFR
VPRpartial
VPRcomplete
VFR
7.09
4.25
0.02
0.69
0.15
0.83
0.008
0.039
0.880
0.407
0.698
0.362
MPRpartial
MPRcomplete
MFR
VPRpartial
VPRcomplete
VFR
Control variables
Pseudo R2
n
134
partner rotations have a significant and positive effect on an auditor's reporting conservatism in regions with weak legal institutions, whereas complete mandatory partner rotations
have a similar but much weaker effect, possibly due to a greater loss of client-specific
knowledge of the client when replacing both of the signing auditors.
7. Conclusions
The post-Enron era has witnessed a growing concern with the issues of auditor independence and audit quality. Legislators, regulators, and professional bodies have suggested
mandatory auditor rotation at both the partner and the firm level after a fixed period of tenure as a method to enhance auditor independence. Recent studies show that institutional
and market development factors such as the legal environment and investor protection affect audit quality. Institutional environments vary dramatically across China, which provides us with the opportunity to test the institutional background to audit rotation. Using
Chinese data and the likelihood of receiving a modified audit opinion as the audit quality
proxy, we find that mandatory audit partner rotations are associated with a significantly
higher likelihood of receiving a MAO than the no-rotation group. However, this effect is
limited to clients in regions with weak legal institutions. We find similar evidence for voluntary audit firm rotation although the significance level is much weaker than for mandatory partner rotation. As to other forms of auditor rotation (i.e., mandatory audit firm
rotation and voluntary audit partner rotation), we find no evidence that they have an effect
on the issuance of a MAO. Overall, we document a positive effect of mandatory audit partner rotation on audit quality in regions with weak legal institutions. However, we fail to
find robust evidence that mandatory audit firm rotation is significantly superior to other
forms of auditor rotation.
Our findings have implications for legislators, regulators, and practitioners in China and
other jurisdictions that have implemented or seriously discussed mandatory auditor rotation policies. However, we advise caution in interpreting our findings, because there are
notable differences in the institutional backgrounds and auditing regimes for auditor rotations across various jurisdictions (e.g., a partner-visible auditing regime in China and Australia vs. a partner-invisible auditing regime in most markets, including the United States;
and a single leading partner regime vs. a two leading partner regime). Moreover, most of
the mandatory audit firm rotation cases in the current study may not be the typicallydebated type of mandatory audit firm rotation (which is supposed to operate in a periodic
manner). These variations suggest that legislators and regulators worldwide face challenges when they try to formulate uniform requirements for mandatory auditor rotation, either at the partner or the firm level, and further study in this regard is warranted.
Appendix A. Examples of mandatory audit firm rotation in China
Case 1. Mandatory audit firm rotation due to regulatory sanctions.
Basic information: Chang Chun Eurasia Group Co. Ltd., listed on the Shanghai Stock
Exchange, stock code 600697. Mandatory audit firm rotation took place prior to the
2001 annual audit.
135
Corporate public announcement of auditor switching event: Regulators canceled the

practicing license of the Zhongtianqin CPA firm, which the company had hired as its auditor. As discussed and approved at the 2001 Interim Shareholders' Meeting, the company
decided to hire the Lianda Xinlong CPA firm as its new auditor.
Case 2. Mandatory audit firm rotation due to non-regulatory organization termination.
Basic information: Jinxi Axle Co. Ltd., listed on the Shanghai Stock Exchange, stock
code 600495. Mandatory audit firm rotation took place prior to the 2005 annual audit.
Corporate public announcement of auditor switching event: As discussed and approved
by the 5th meeting of the Board of Directors, the company planned to continue its audit
engagement with the Shanxi Tianyuan CPA firm with an estimated audit fee of
RMB250,000. However, Shanxi Tianyuan announced that it had gone into liquidation
on May 31, 2005. After receiving the notification letter from Shanxi Tianyuan, the company held its 7th meeting of the Board of Directors and approved the engagement of the Beijing Jingdu CPA firm as its new auditor, without changing the audit fee.
Case 3. Mandatory audit firm rotation due to regulatory requirement.
Basic information: South Huiton Co. Ltd., listed on the Shenzhen Stock Exchange, stock
code 000920. Mandatory audit firm rotation took place prior to the 2004 annual audit.
Corporate public announcement of auditor switching event: According to the policy issued by the State-owned Assets Supervision and Administration Commission of the State
Council (SASAC) on changing the audit firm for the 2004 annual report, Southern China
Locomotive and Rolling Stock Industrial Corporation, the controlling shareholder of the
company, was on the SASAC program list for the uniform designation of auditors. As
agreed at the 12th meeting of the Board of Directors held on January 21, 2005, the company resolved to engage the Lianda Xinlong CPA firm, which had been designated by the
SASAC as the new auditor, thus dismissing its previous auditor, the Beijing Xinghua
CPA firm.
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How Do Various Forms of Auditor Rotation Affect Audit Quality? Evidence From China

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The International Journal of Accounting

How Do Various Forms of Auditor Rotation Affect

Department of Finance and Insurance, Lingnan University, Hong Kong

M. Firth et al. / The International Journal of Accounting 47 (2012) 109138

M. Firth et al. / The International Journal of Accounting 47 (2012) 109138

A more detailed literature review is provided in the next section.

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As to whether mandatory auditor rotation enhances actual FRQ/AQ, a number of recent

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M. Firth et al. / The International Journal of Accounting 47 (2012) 109138

What is the main reason for the mandatory

A number of international and domestic corporate scandals

Some people argue that mandatory audit

M. Firth et al. / The International Journal of Accounting 47 (2012) 109138

M. Firth et al. / The International Journal of Accounting 47 (2012) 109138

M. Firth et al. / The International Journal of Accounting 47 (2012) 109138

For brevity, we do not include subscripts i and t to denote rm and year.

M. Firth et al. / The International Journal of Accounting 47 (2012) 109138

LOCGOV a dummy variable equal to 1 if the ultimate controlling shareholder is at the

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3.3. Market development level

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M. Firth et al. / The International Journal of Accounting 47 (2012) 109138

M. Firth et al. / The International Journal of Accounting 47 (2012) 109138

Strong legal institution

Weak legal institution

M. Firth et al. / The International Journal of Accounting 47 (2012) 109138

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Two-tailed p-values are reported in parentheses.

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6.2. Alternative approach to partitioning the sample

M. Firth et al. / The International Journal of Accounting 47 (2012) 109138

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Strong legal institution

Weak legal institution

Diff. in coeff. (strong vs. weak legal institutions)

M. Firth et al. / The International Journal of Accounting 47 (2012) 109138

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Mandatory audit partner rotation

Voluntary audit partner rotation

Panel B: logistic regression results

Diff. in coeff. (Strong vs. weak legal institutions)

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Corporate public announcement of auditor switching event: Regulators canceled the

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M. Firth et al. / The International Journal of Accounting 47 (2012) 109138

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