Do Investors Perceive A Change in Audit Quality Following The Rotation of The Engagement Partner. 2019

J. Account.
Public Policy 38 (2019) 146–168
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J. Account. Public Policy

journal homepage: www.elsevier.com/locate/jaccpubpol
Full length article
Do investors perceive a change in audit quality following the

rotation of the engagement partner? q
Gopal Krishnan a,⇑, Jing Zhang b
a
Department of Accountancy, Bentley University, 175 Forest Street, Waltham, MA 02452, United States
b
Department of Accounting, Business School, University of Colorado Denver, 1475 Lawrence Street, Denver, CO 80202, United States
a r t i c l e i n f o a b s t r a c t
Article history: Though Section 203 of the Sarbanes-Oxley Act (SOX) calls for the rotation of the audit part-
Available online 28 February 2019 ner every five years, we do not know whether investors value audit partner rotation. This is
an important issue since many in the auditing profession believe that mandatory rotation
Keywords: of the audit partner is unnecessary and may in fact impair audit quality. We identify a sam-
Audit partner rotation ple of firms that disclosed changes in the engagement partner in the proxy statement and
Earnings informativeness examine whether equity investors perceive a change in audit quality following the partner
Cost of equity
rotation. We find a significant increase in earnings informativeness following audit partner
Short sellers
rotation. We also find that short sellers regard earnings in the post-rotation to be of higher
quality than earnings prior to the rotation. Finally, cost of equity capital is lower following
partner rotation. Our findings have important implications for the regulators, auditors, and
investors.
Ó 2019 Elsevier Inc. All rights reserved.
1. Introduction
Section 203 of the Sarbanes-Oxley Act (SOX) calls for the rotation of the audit partner every five years.1 An implicit
assumption behind Section 203 is that rotation of audit partner enhances audit quality.2 Bamber and Bamber (2009) state,
‘‘. . . there has been little empirical evidence on the costs or benefits of audit partner rotation because of lack of data; . . . there
is a real need for scientific evidence on the extent to which rotation yields the benefits regulators anticipate.” We respond to this
call by examining equity investors’ perceptions of audit partner rotation. Our study is motivated by the paucity of empirical
evidence on how investors perceive the effect of the rotation of the engagement partner on audit quality. To the best of our
knowledge, no prior study has examined investors’ perceptions of audit partner change for U.S. firms. In a review of research
on audit partners, Lennox and Wu (2017, 32) state, ‘‘Overall, extant US studies provide somewhat mixed evidence on the con-
sequences of partner rotation.”
q
We thank the participants at the 2016 inaugural Conference on Capital Market-Based Accounting Research, University of Muenster, two anonymous
reviewers for the 2017 AAA Annual Meeting, an anonymous reviewer, and the 2018 Journal of Accounting and Public Policy Conference participants for helpful
comments and suggestions.
⇑ Corresponding author.
E-mail addresses: gkrishnan@bentley.edu (G. Krishnan), jing.zhang@uah.edu (J. Zhang).
1
The AICPA required mandatory rotation of the audit partner long before SOX. SOX accelerated the rotation period from seven to five years and extended the
cooling-off period from two to five years.
2
We use the terms ‘‘audit partner”, ‘‘partner”, ‘‘engagement partner”, and ‘‘concurring partner” synonymously.
https://doi.org/10.1016/j.jaccpubpol.2019.02.002
0278-4254/Ó 2019 Elsevier Inc. All rights reserved.
G. Krishnan, J. Zhang / J. Account. Public Policy 38 (2019) 146–168 147
Investor perception of audit partner tenure reflects the net effect (costs and benefits) of mandatory auditor rotation and
empirical evidence on investor perception could contribute to our understanding of the economic consequences of Sec-
tion 203 of SOX.3 Ex ante, the perceived effect of audit partner rotation on audit quality is unclear. On one hand, audit partner
rotation brings a fresh perspective to the audit and results of the interviews and field surveys indicate that partners believe that
partner rotation improves independence in both fact and appearance (Daugherty et al., 2012).4 The improvement in indepen-
dence is expected to enhance audit quality. On the other hand, partner rotation could have an adverse impact on audit quality
due to increased information asymmetry due to less history of client interaction (Bedard and Johnstone, 2010). To put it differ-
ently, over time, auditors can gain firm-specific expertise which helps them to understand the client’s business and rely less on
management estimates (Myers et al., 2003). Further, Daugherty et al. (2012) document an unintended consequence of partner
rotation that may have an adverse impact on audit quality. Rotation may result in partner relocation but, due to quality-of-life
considerations, partners may opt to gain new industry experience (retrain) in order to avoid relocation. In other words, partners’
preferred response to rotation is to choose to retrain to preserve their quality of life at the expense of audit quality. Thus, the net
effect of audit partner rotation on the perceived audit quality is an open and timely issue.
As the disclosure of audit partner rotation is voluntary, we review the proxy statements of all firms available on EDGAR
for the years 2002 through 2015 and develop an algorithm (described in Section 4) to identify firms that disclosed informa-
tion on rotation of audit partner for that year.5 We are able to confirm rotation of audit partner for 53 observations represent-
ing 40 unique firms. We also make sure that the change in the audit partner occurred without the change of the auditor.
To examine investors’ perceptions of audit partner rotation on audit quality, we employ a pre- vs. post-rotation design by
testing differences in perceived audit quality measures between two years before the partner rotation and two years after
the rotation (including the year of rotation). We use multiple proxies to capture investors’ perceptions of audit partner rota-
tion: earnings response coefficient, short sellers’ response to earnings, and multiple measures of cost of equity capital.
We document several key findings. First, the informativeness of earnings (earnings response coefficient) has increased by
about 21.86% during the post-rotation period relative to the pre-rotation period. Second, abnormal earnings in the post-
rotation period is negatively associated with the proportion of outstanding shares shorted as well as the extent of abnormal
short sales, indicating that short sellers regard earnings in the post-rotation to be of higher quality. Third, the reduction in
cost of equity capital following the audit partner rotation ranges from 80 bps to 150 bps. These findings are consistent with
the notion that investors perceive lower information risk as a result of audit partner rotation. Overall, these results suggest
that investors perceive the rotation of lead audit partner enhancing audit quality.
To mitigate the endogeneity issue associated with the voluntary disclosure of audit partner rotation, we employ propen-
sity score matching to match firms that disclosed partner rotation (treatment firms) with non-disclosing firms (control
firms) and repeat our analyses using the matched sample. We find that compared to the control firms that have a similar
propensity to voluntarily disclose the audit partner change, the treatment firms experience an increase in perceived audit
quality after the rotation of audit partner. To rule out the possibility that our findings are driven by some time-varying fac-
tors that are not related to audit partner change, we conduct a placebo test. For each of our rotation observation, we assign a
‘‘pseudo rotation year” which is two years before the real rotation year. Next, we examine whether there is a change in per-
ceived audit quality between the two years before the pseudo rotation year and the two years after (including the pseudo
rotation year), and we do not observe a significant change in perceived audit quality for any of the three measures of per-
ceived audit quality.
Finally, as part of additional analyses, we also examine the relation between audit partner rotation and multiple measures
of audit quality used in prior research (DeFond and Zhang, 2014): earnings persistence, earnings predictability of future cash
flows, and meeting or beating earnings benchmarks. We find that for a sub-sample of smaller firms (firms followed by fewer
analysts), earnings persistence is higher by about 90% (147%) during the post-rotation period relative to the pre-rotation per-
iod. Next, the predictive value of earnings for future cash flows is higher by about 85% (31%) for smaller firms (firms followed
by fewer analysts) during the post-rotation period. Further, the likelihood of meeting or beating small earnings is signifi-
cantly lower following the audit partner rotation for smaller firms (firms followed by fewer analysts). The above results
are consistent with the notion that audit partner rotation has a favorable effect on audit quality for smaller firms and firms
that are followed by fewer analysts. We also find some evidence that audit partner rotation has an adverse effect on audit
quality for more complex firms, where audit partners’ learning costs are expected to be high.
We make several contributions to the literature on audit partner tenure. First, to the best of our knowledge, we are one of
the first studies to look at investors’ perceptions of audit partner rotation in the U.S. Our findings inform members of the U.S.
Congress, the SEC, the PCAOB, investors, auditors, and others about the potential benefits of rotation of the audit partner.
3
We examine general equity market investors as well as sophisticated investors (discussed in Section 3).
4
While audit firm rotation is likely to have a bigger impact on audit quality than audit partner rotation, prior research finds that audit quality varies among
audit partners even within the same audit firm due to differences in skill set, incentives to provide a high-quality audit, nature of the partner-client
relationships, and client demands. Thus, though continuity could be preserved when there is a rotation of the audit partner without change of the audit firm,
the new audit partner has substantial flexibility with regard to how the audit is planned, executed, and exercise judgment on key audit matters. Thus, if
investors believe that partner rotation brings a ‘‘new set of eyes”, then they are likely to perceive a higher audit quality following the partner rotation. This is
the implicit assumption behind Section 203 of SOX.
5
Identity of the engagement partner is available for U.S. firms effective 2017. However, a longer time series is needed to identify a sample of firms subject to
rotation of the engagement partner. As of April 2018, we are able to identify firms that rotated audit partner in fiscal year 2017. However, the information
needed to estimate the models of investor perception for the post-rotation years is currently unavailable.
148 G. Krishnan, J. Zhang / J. Account. Public Policy 38 (2019) 146–168
Second, our findings are potentially important since many in the auditing profession believe that mandatory rotation of the
audit partner is unnecessary and may in fact impair audit quality (AICPA, 1992; Wallman, 1996; Daugherty et al., 2012). We
contribute to this debate by providing empirical evidence on how equity market participants perceive the net effect of audit
partner rotation on audit quality, taking into account both the costs and benefits associated with the partner rotation. By
doing so, we also contribute to the larger literature on the effects of SOX on investor perception of accounting information
(Lopez et al., 2009; Kalelkar and Nwaeze, 2011). Third, we provide direct empirical evidence on whether audit partner rota-
tion enhances audit quality. We find that, at least for smaller firms and firms followed by fewer analysts, there is a significant
improvement in audit quality following partner rotation.
The remainder of this paper is organized as follows. The next section summarizes prior research on audit partner rotation
and develops the hypothesis. Section 3 describes measures of perceived audit quality and the empirical models. Section 4
describes the sample selection. Results are in section five followed by conclusions.
2. Prior research and hypothesis
We are not aware of a study that examines investor perceptions of audit partner rotation for U.S. firms. Chi et al. (2009)
examine the market perception of mandatory audit partner rotation in Taiwan but do not find that mandatory rotation
enhances audit quality.6 Further, it is not clear whether the (lack of) findings in Chi et al. (2009) extend to the U.S.
Next, we review prior research on the effect of audit partner rotation on audit quality for U.S. firms. Kaplan and Mauldin
(2008) conduct experiments to study the effect of auditor independence on non-professional investors (MBA students). They
find that students’ perceptions of auditor independence were not significantly different under audit firm or partner rotation.
The authors interpret these findings as evidence that audit firm rotation and audit partner rotation have a similar effect on
auditor independence. Our study differs from Kaplan and Mauldin (2008) by focusing on professional investors and holding
the audit firm constant to tease out the effect of engagement partner change on audit quality.
Using proprietary data from audits completed in years 1999 through 2001, Manry et al., (2008) find that audit quality
increases with audit partner tenure only for small clients with partner tenure of greater than seven years, but not signifi-
cantly associated with large clients. Bedard and Johnstone (2010) study the relation between audit engagement partner
tenure and audit planning and pricing using proprietary data from an audit firm representing audits conducted during
2002 and 2003. They find that planned engagement effort increases following partner rotation, consistent with the notion
that partners invest effort to gain client knowledge in the first year of the engagement and to reduce the information asym-
metry they face in directing a first-time audit. Litt et al. (2014) provide evidence of lower financial reporting quality (higher
discretionary accruals) following an audit partner change, especially for larger clients, suggesting that audit partner rotation
can have a negative effect on audit quality. Sharma et al. (2017) find higher audit fees and longer audit report lags in the
period immediately following audit partner rotation, suggesting that partner rotation increases audit production costs.
Laurion et al. (2017) examine the SEC comment letters to identify the audit partner name (presumed to be the engagement
partner) and identify partner rotation when there is a change in audit partner and find that there is no change in the fre-
quency of misstatements following partner rotation. However, they find an increase in the frequency of restatement discov-
eries following partner rotation. Thus, there is some evidence that audit partner rotation improves audit quality. We
complement their study by using a more accurate way to identify firms with audit partner rotation.7 We search and identify
firms which disclosed audit partner rotation in the proxy statement. More importantly, neither Litt et al. (2014) nor Laurion
et al. (2017) examine investor perception of audit partner rotation, the focus of this study. In addition, we examine several mea-
sures of audit quality not examined by Laurion et al. (2017).
There is also prior research on audit partner rotation using data from non-U.S. settings. Focusing on Taiwanese firms, Chi
and Huang (2005) find that longer audit partner tenure is associated with lower discretionary accruals i.e., higher earnings
quality. A similar conclusion is shared by Chen et al. (2008). These findings suggest that mandatory partner rotation might be
detrimental to audit quality. Focusing on Australian firms, several studies examine the relation between audit partner tenure
and audit quality. Hamilton et al. (2005) find that audit partner rotation is associated with a reduction in aggressive account-
ing by clients of Big 5 auditors. Carey and Simnett (2006) focus on year 1995 which was before the introduction of manda-
tory requirements on audit partner tenure in Australia. They find that the propensity to issue going concern opinion
diminishes over audit partner’s tenure, suggesting a reduction in audit quality, particularly for non-big 6 auditors. Ye
et al. (2011) re-examine the relation between going concern opinion and audit partner tenure and find that longer the
engagement partner tenure, the lower is the likelihood of issuing a going concern opinion, consistent with findings in
Carey and Simnett (2006). However, in a more recent study, Monroe and Hossain (2013) revisit this issue using data from
a period after the introduction of mandatory audit partner rotation and find a positive association between the likelihood
of issuing going concern opinions and audit partner tenure when tenure is five years or more. Finally, focusing on Chinese
6
Also using data from Taiwan, Aobdia et al. (2015) find a positive market reaction when a firm replaces a lower quality partner with a higher quality partner
but they focus on capital market consequences of partner fixed effects rather than rotation of the engagement partner, the focus of this study.
7
SEC comment letters are issued on average every two years and Laurion et al. (2017) are not able to identify the exact rotation year.
firms, Lennox et al. (2014) find that mandatory rotation of engagement partners results in higher quality audits in the years
immediately surrounding the rotation. We contribute to the above literature by focusing on U.S. firms.8
In summary, findings from prior research are mixed regarding how audit partner rotation affects audit quality. Some
studies indicate that audit partner rotation can enhance audit quality due to increased auditor independence both in fact
and appearance and increased audit effort in the year of the partner change (Bedard and Johnstone, 2010; Monroe and
Hossain, 2013; Lennox et al., 2014). Further, evidence from behavioral research suggests that partners who are new to an
engagement are more likely to conclude goodwill may be impaired relative to continuing partners, consistent with the ‘‘fresh
look” perspective (Favere-Marchesi and Emby, 2005).
On the other hand, prior research also notes that audit partner rotation can exacerbate audit quality due to lost client-
specific knowledge (Myers et al., 2003; Wallman, 1996) and partners’ preference to retrain rather than relocate due to
quality-of-life considerations (Daugherty et al., 2012). Further, Wallman (1996), a former SEC Commissioner argues that
periodic rotation of audit firms is contrary to the notion of learning as much as possible about the audit client and rotating
auditors might increase the occurrence of problem audits.
Given the opposite predictions of the effect of audit partner rotation on audit quality and the lack of empirical evidence on
perceived audit quality following audit partner rotation, it is an empirical issue whether or not investors perceive rotation of
audit partner as enhancing or exacerbating audit quality. Thus, we present our hypothesis in null form as follows:
Hypothesis 1. Investors do not perceive a change in audit quality following the rotation of the audit partner.
3. Research design
To examine whether investors perceive a change in audit quality following the rotation of the audit partner, we employ a
pre- vs. post-rotation design by estimating a regression model (described below) to test differences in investors’ perception
measures (described below) between eight quarters (two years) before the partner rotation and eight quarters (two years)
after the rotation (including the year of rotation).9 We measure investors’ perceptions of audit quality in three ways. First is
earnings response coefficient (ERC). Consistent with prior research, we interpret higher ERC as evidence of higher perceived
audit quality (Teoh and Wong, 1993; Ghosh and Moon, 2005; Francis and Ke, 2006). Second, in addition to examining the
responsiveness of the general market investors to earnings, we focus on a group of sophisticated market investors, namely,
the short sellers. It has been argued that short sellers are better at analyzing and processing financial information and are able
to identify firms with poor earnings quality (Desai et al., 2006; Karpoff and Lou, 2010). Our third measure of investors’ percep-
tion of audit quality is cost of equity capital. Prior research finds that auditor credibility is inversely related to cost of equity
capital (Khurana and Raman, 2006). We describe below the empirical models that employ these measures of investor percep-
tions to test our hypothesis.
3.1. Empirical models
3.1.1. Earnings response coefficient

Prior literature documents that information in earnings should be correlated with the information used by market inves-
tors in their equity valuation decisions, if investors believe the earnings is of ‘‘high-quality” (Holthausen and Verrecchia,
1988). Hence, we use the following basic return-to-earnings regression model (Christensen et al., 2004; Teoh and Wong,
1993) to analyze the effect of audit partner rotation on the market responsiveness to earnings news:
CAR ¼ b0 þ b1 UE þ b2 UE ROTATE þ b3 ROTATE þ b4 UE SIZEQ þ b5 UE LEVQ þ b6 UE MBQ þ b7 SIZEQ
þ b8 LEVQ þ b9 MBQ þ RIND þ RYEAR þ e ð1Þ
The dependent variable CAR is the cumulative value-weighted market-adjusted abnormal return over 3-day or 5-day
around the announcement of quarterly earnings.10 The expected earnings are measured using the most recent median consen-
sus analysts’ forecast of earnings per share (EPS), obtained from I/B/E/S, prior to the earnings announcement. The median ana-
8
There are important differences between Taiwan and other countries that may limit the generalizability of findings to other countries, such as the U.S. Chen
et al. (2008) note that in Taiwan audit firms must be formed as unlimited liability partnerships or proprietorships whereas in the U.S., U.K., and Australia audit
firms are formed as limited liability partnerships. More importantly, Chen et al. (2008) note that the legal enforcement mechanism in Taiwan is weaker relative
to those in Western countries.
9
We use two years after the rotation to make sure that there is enough time for investors to know that audit partner change has occurred. Also, 16 of our
sample firms disclosed the news of audit partner change in the proxy statement of rotation year, which means the news of audit partner rotation is not
available to general public until the year after the rotation year. For these observations, we can use the second year after rotation in conducting tests of
perceived audit quality. Finally, Daugherty et al. (2012) conduct interviews with audit partners and report that it might take two to three years for the audit
partner to become familiar with the new client. Thus, we believe focusing on two years before and after the rotation is appropriate.
10
Another way to capture the abnormal return is to cumulate the abnormal return from the day of the consensus analysts’ forecast to the day of the earnings
announcement (Teoh and Wong, 1993). However, a drawback of this approach is that this measure of abnormal return is noisier due to other announcements
made during this time interval. As a robustness test, we use the cumulative abnormal return from the consensus forecast day to the earnings announcement
day as the dependent variable and our results are qualitatively similar.
lyst forecast is computed using each analyst’s latest forecast before the earnings announcement date, but after the prior quar-
ters’ earnings announcement date. The unexpected earnings, UE, is equal to actual EPS minus the expected EPS for the quarter,
scaled by the stock price of the previous quarter. Our interest is in the coefficient on UE ROTATE (b2). If investors perceive
earnings quality and audit quality as improving with the rotation of the lead audit partner, b2 is expected to be positive. On
the other hand, a negative coefficient would be consistent with investors perceiving audit partner rotation impairing audit
quality.
3.1.2. Short selling

We use the following regression model to analyze short sellers’ perception of earnings quality during the pre-and post-
rotation of the lead audit partner.
SI=ABSI ¼ b0 þ b1 UE þ b2 UE ROTATE þ b3 ROTATE þ b4 SIZEQ þ b5 LEVQ þ b6 BMQ þ b7 RET þ b8 TURN þ b9 INSTQ

þ RIND þ RYEAR þ e ð2Þ
We use two measures of short interest: the short-interest ratio (SI), and the abnormal short-interest ratio (ABSI). SI is
commonly used in the literature (Jones and Larsen, 2004; Karpoff and Lou, 2010). It is the number of shares shorted divided
by the number of outstanding shares in the month of earnings announcement. Short interest has been shown to be associ-
ated with certain firm characteristics. Dechow et al. (2001) and Asquith et al. (2005), among others, show that short selling
increases with firm size. Dechow et al. (2001) document a negative association between short interest and the ratio of book-
value of equity to market-value of equity. Asquith et al. (2005) show that short interest is negatively related to return
momentum. D’Avolio (2002) demonstrates that the effectiveness of short sales depends on the ease of share borrowing.
Therefore, we include the following control variables in model (2): SIZEQ, measured as the natural logarithm of quarterly
total assets; LEVQ, the quarterly leverage, the ratio of total liability over total assets; BMQ, the quarterly book to market ratio;
RET, the cumulative raw stock return over the previous six months; TURN, the share turnover, measured as shares traded
scaled by the total shares outstanding, and averaged over the previous six months; and INSTQ, the percentage of shares held
by institutional investors in the quarter.
Next, we construct a measure of abnormal short interest, which controls for the effects of size, book-to-market ratio and
return momentum. Following Karpoff and Lou (2010) and Desai et al. (2006), all firms in the CRSP database are first sorted
into three groups, based on their preceding month-end’s market capitalization. Within each size group, firms are further
sorted into three groups based on their prior fiscal-year-end’s book-to-market ratio. The same procedure follows for return
momentum. The outcome of the three-parameter sorting process is a formation of 27 portfolios at the beginning of each
month. The expected short interest for each firm i in month t, E(Sift), is the median value of the short interest of its corre-
sponding matching portfolio. Next, we define abnormal short interest, ABSIi,t, as the difference between the firm’s actual
and expected short interest. Our interest is in the coefficient on UE ROTATE (b2), which captures the difference in short sell-
ers’ response to earnings information during the pre-and post-audit partner rotation. If the short sellers perceive the rotation
of audit partner as improving (impairing) earnings quality, b2 is expected to be negative (positive).
3.1.3. Cost of equity capital

Prior studies have shown that increased financial reporting transparency could decrease the adverse selection problem
and improve liquidity. Consequently, cost of equity capital (COE) will be lower due to greater demand for the firm’s securities
and reduced transaction costs (Easley and O’Hara, 2004; Diamond and Verrecchia, 1991). Further, Francis et al. (2004 and
Franciset al. (2005)) find that information risk, i.e., accounting information quality is priced by investors. If audit partner
rotation enhances or exacerbates perceived audit quality, then we expect investors to demand a lower or higher cost of
equity, respectively. We use the following model to test the relation between cost of equity capital and audit partner rotation
(Callahan et al., 2012):
COE ¼ b0 þ b1 ROTATE þ b2 SIZEQ þ b3 LEVQ þ b4 GROWTH þ b5 BETA þ b6 BETASD þ b7 CASHSD þ RIND þ RYEAR þ e
ð3Þ
We employ three accounting-based proxies for firms’ implied cost of equity capital that are widely used in prior research.
All three proxies are forward-looking measures that are based on analysts’ estimates of future earnings. Our first proxy is
based on Easton’s (2004) PEG ratio, measured using the following equation:
CEOPEG ¼ sqrtððEPS2 EPS1 Þ=Price0 Þ ð4Þ
EPS1 and EPS2 are, respectively, the last mean earnings per share forecasts in the quarter for fiscal years t + 1 and t + 2,
while Price0 is the market price of the firm at the end of the quarter. Only firms with positive earnings growth have available
COEPEG measure.11
The second proxy is based on Ohlson and Juettner-Nauroth (2005)’s model:
11
Botosan and Plumlee (2005) assess the relative reliability of five popular approaches to estimate the cost of equity capital and conclude that the COEPEG
measure is consistently and predictably related to market risk, leverage risk, information risk, residual risk (as measured by firm size and or book-to-price),
growth and recommend this measure for estimating firm-specific estimates of cost of equity capital.
COEOJ ¼ A þ sqrtðA2 þ ðEPS2 EPS1 Þ=ðg ðc 1ÞÞ A ¼ ð1=2Þ ððc 1Þ þ DPS1 =Price0 Þ ð5Þ
In this equation, EPS1 and Price0 are defined the same as above. DPS1 is the dividend per share in the current year, and g is
the earnings growth percentage from fiscal year t + 1 to fiscal year to t + 2. Following Hribar and Jenkins (2004), c 1 is the
long-term growth rate measured as risk-free rate less 3%, and the risk-free rate is the 10-year U.S. Treasury bond rates.
Our third cost of equity capital measure (COEGLS) is based on Gebhardt et al. (2001)’s model which is based on Ohlson’s
residual valuation model (Ohlson, 1995):
FROEtþ1 r FROEtþ2 r
Pt ¼ Bt þ Bt þ Btþ1 þ TV
1þr ð1 þ rÞ2
XT1 FROEtþi r FROEtþT r

TV ¼ Btþi1 þ BtþT1 ð6Þ
i¼3
ð1 þ rÞ i
ð1 þ rÞT1
In this equation, r is the cost of equity capital (COEGLS), Pt is the market price of the firm at the end of the quarter, Bt is the
book value per share at the beginning of the quarter, FROEt+1 is the forecasted return on equity for fiscal year t + 1, and TV is
the terminal value. We follow Callahan et al. (2012) to set T = 12 and calculate FROEt+3 by multiplying EPSt+2 by one plus the
IBES’s forecasted long term growth rate. Then we use industry median ROE, measured as 10-year average for Fama and
French’s 48 industry classifications as the proxy for ROEt+12.12 From fiscal year t + 4 to fiscal year t + 12, we assume that
ROE linearly reverts to the ROEt+12.13 Based on clean surplus accounting theory, we calculate Bt+1 = Bt + (1 payout ratio)
EPSt+1, where the payout ratio is measured as the current dividends per share divided by current earnings per share.14 Finally,
following prior research (Hail and Leuz, 2006, 2009; Callahan et al., 2012), we use an aggregate measure of implied cost of
equity capital, COEAVE, which is the first principal component of the above three individual measures of cost of equity capital.15
We follow the prior literature to include a set of control variables that are likely to be associated with implied cost of
equity capital (Dhaliwal et al., 2007; Callahan et al., 2012). First, we control for firm size, SIZEQ, and leverage, LEVQ, measured
as the natural logarithm of quarterly total assets, and the ratio of quarterly total liability to total assets, respectively. Second,
to control for firm risk, we include the beta factor, BETA, calculated with the single factor value-weighted market model using
the previous 60 months returns information; standard deviation of beta over previous year, BETASD; and the standard devi-
ation of operating cash flow over the previous five years, CASHSD. Last, we control for firm growth, GROWTH, measured as the
change in quarterly operating income divided by the previous quarter’s total assets. Detailed variable definitions are pro-
vided in Appendix B. The variable of interest in model (3) is ROTATE. A positive (negative) coefficient on ROTATE would be
consistent with lower (higher) perceived audit quality due to higher (lower) information risk as a result of audit partner
rotation.
4. Sample selection
We review the proxy statements (DEF 14A files) of all firms available on EDGAR for the years 2002 through 2015 to iden-
tify our sample firms. We develop an algorithm using PERL program to search the proxy statements with the following key-
words: ‘‘audit partner”, ‘‘engagement partner”, ‘‘new partner”, ‘‘rotation”, ‘‘rotate”. This search resulted in 1271 proxy
statements. Next, we read each of the selected proxy statement to see whether the firm has disclosed information on rota-
tion of audit partner. Out of the 1271 proxy statements, we are able to confirm rotation of audit partner for 53 observa-
tions.16 Examples of disclosure on audit partner rotation in the proxy statements appear in Appendix A. After carefully
reviewing each disclosure of audit partner change, we find that 37 (70%) firms specifically stated that their audit partner change
is due to the mandatory rotation of the audit partner under SOX, 11 (21%) firms mentioned the mandatory rotation requirement
in the disclosure, and 5 (9%) firms did not provide a reason for the partner change. Thus, we believe that for more than 90% of
the sample, the partner rotation is driven by SOX Section 203. Next, we collect stock market information from CRSP, analyst
forecast information from IBES, information on short selling from COMPUSTAT supplement short interest file, and additional
financial statement data from COMPUSTAT. For each rotation observation, we collect data for eight fiscal quarters (two years)
before and after the rotation of the audit partner (including the year of partner rotation). Among the 53 observations, eight
did not disclose the auditor partner rotation information around the rotation years, instead, it was disclosed a few years after
the rotation. Hence, we exclude these observations.17 In addition, there are 14 observations for which audit partner rotation was
disclosed in the proxy statement of rotation year, which means the news of audit partner rotation is not available to general
public only until the year after the rotation year. For these observations, we exclude the year of partner rotation. The above pro-
12
Following Dhaliwal et al. (2005) and Callahan et al. (2012), all loss firms are excluded from the calculation of industry median ROE.
13
ROE is constrained to be greater than zero and is winsorized at 1%.
14
If the earnings per share are negative, we calculate the dividend payout ratio using current dividends divided by 6% of total assets (Hribar and Jenkins,
2004; Callahan et al., 2012).
15
The first component has an eigenvalue of 2.313 and accounts for 77.1% of the variance of the observed variables. The factor loadings for COEPEG, COEOJ, and
COEGLS are, respectively, 0.684, 0.635, and 0.440.
16
We read each proxy statement to make sure that the audit partner change occurred without the change of the auditor.
17
For example, RLI Corp. switched their lead audit partner in fiscal year 2010. But the information was disclosed in its 2013 proxy statement.
Table 1
Industry distribution.
Rotation year No. of Obs. Manufacture Service Financial Wholesale Retail Utility Total
2002 1 0 1 0 0 0 0 1
2003 2 2 0 0 0 0 0 2
2004 1 1 0 0 0 0 0 1
2005 2 1 1 0 0 0 0 2
2007 4 0 2 2 0 0 0 4
2008 1 1 0 0 0 0 0 1
2009 6 1 1 2 1 1 0 6
2010 5 2 1 1 0 0 1 5
2011 2 0 0 1 1 0 0 2
2012 2 2 0 0 0 0 0 2
2013 5 2 0 2 0 0 1 5
2014 9 3 1 3 1 1 0 9
2015 13 6 2 3 0 2 0 13
Total 53 21 9 14 3 4 2 53
This table reports the number of firm-year observations for which audit partner rotation information is reported in the proxy statements for the years 2002
through 2015.
cess results in a sample of 437 firm-quarter observations for which stock return data are available, 295 firm-quarter observa-
tions for which short interest data are available, and 340 firm-quarter observations for which necessary data are available to
calculate the cost of equity capital.
4.1. Univariate results
Industry distribution of the sample appears in Table 1. The number of observations for which audit partner is rotated and
disclosed is the highest for fiscal years 2014 and 2015, indicating that more firms are disclosing information about audit
partner rotation in recent years. The top three industries reporting audit partner information are, manufacturing, financial,
and service firms.
Descriptive statistics for the sample are in Table 2. The mean and median values of total assets for our sample are, respec-
tively, $35.971 billion and $13.876 billion (untabulated).18 The mean five-day cumulative market adjusted stock return around
the earnings announcement date is about 0.153%. The mean value of the proportion of outstanding shares shorted is about
3.670% and the mean abnormal short interest is about 0.421%. The mean values of cost of equity capital based on Easton
(2004) and Ohlson and Juettner-Nauroth (2005) and Gebhardt et al. (2001) are, respectively, 0.089, 0.092 and 0.077.
Pearson correlations in Table 3 indicate that the variable of interest, ROTATE is negatively associated with all four mea-
sures of cost of equity capital (significant at the 0.10 level or better), suggesting that equity investors perceive audit partner
rotation enhancing audit quality. ROTATE is not significantly associated with short selling or cumulative stock returns. Next,
we discuss results of models (1), (2), and (3).
5. Results
5.1. Earnings response coefficient
Results of earnings response coefficient (model 1) are in Table 4. In all models, we include year and industry fixed effects.
The reported p-values are based on robust standard errors that are clustered by firm and quarter. We present results for two
dependent variables: the 3-day cumulative market-adjusted stock return around the earnings announcement date (CAR (1,
+1)) and the 5-day cumulative market-adjusted stock return around the earnings announcement date (CAR (2, +2)). Con-
sistent with prior research, the coefficient on UE is positive and significant in columns 1–4. The coefficient on the variable
of interest, UE ROTATE is positive in columns 3 and 4 and significant at the 0.05 level. Our results appear to be economically
significant. Results in column 3 indicate that the informativeness of earnings has increased by about 21.86% (0.740/3.386)
during the post-rotation period relative to the pre-rotation period. Overall, these results reject the null hypothesis and sup-
port the notion that investors perceive the rotation of lead audit partner enhancing audit quality.
5.2. Short selling
Results of model (2) are in Table 5. We use two dependent variables: the short-interest ratio (column 1 and 3) and the
abnormal short-interest ratio which measures the difference between the firm’s actual and expected short interest (column
2 and 4). As expected, the coefficient on UE is negative and significant, indicating that short selling is decreasing in unex-
18
The mean and median values of total assets for firms in the COMPUSTAT database are, respectively, $11.742 billion and $388 million. Thus, relative to the
population firms, firms in our sample are larger. We also partition the sample on firm size and estimate the models separately for smaller and larger firms and
those results are discussed in a later section.
Table 2
Descriptive statistics.
VARIABLE N Mean Median SD P25 P75

Earnings response coefficient sample
CAR (1,+1) 437 0.009% 0.025% 6.340% 2.773% 2.661%
CAR (2,+2) 437 0.153% 0.078% 6.567% 2.752% 3.376%
UE 437 0.003 0.000 0.019 0.003 0.002
ROTATE 437 0.405 0.000 0.491 0.000 1.000
SIZEQ 437 9.405 9.538 1.800 7.930 10.879
LEVQ 437 0.611 0.623 0.214 0.463 0.739
MBQ 437 3.582 2.560 3.127 1.654 4.251
Short selling sample
SI 295 3.670% 1.660% 5.255% 1.070% 3.689%
ABSI 295 0.421% 1.197% 5.430% 2.241% 0.858%
UE 295 0.002 0.000 0.013 0.003 0.002
ROTATE 295 0.308 0.000 0.463 0.000 1.000
SIZEQ 295 9.425 9.517 1.697 8.499 10.834
LEVQ 295 0.566 0.598 0.209 0.436 0.698
BMQ 295 0.441 0.354 0.318 0.234 0.525
MOM 295 0.101 0.097 0.176 0.004 0.196
TURN 295 0.181 0.166 0.084 0.111 0.234
INSTQ 295 0.698 0.705 0.184 0.616 0.815
Cost of equity capital sample
COEPEG 340 0.089 0.085 0.038 0.069 0.101
COEOJ 340 0.092 0.088 0.037 0.072 0.104
COEGLS 361 0.077 0.074 0.025 0.062 0.091
COEAVE 340 0.199 0.361 1.331 0.846 0.324
ROTATE 340 0.397 0.000 0.490 0.000 1.000
SIZEQ 340 9.671 9.662 1.571 8.673 10.995
LEVQ 340 0.593 0.615 0.211 0.456 0.733
GROWTH 340 0.000 0.001 0.010 0.001 0.003
BETA 340 0.717 0.721 0.266 0.604 0.888
BETASD 340 0.062 0.046 0.058 0.024 0.078
CASHSD 340 0.046 0.043 0.025 0.034 0.070
See Appendix B for variable definitions. Observations are fiscal quarters. For each firm-year observation for which audit partner rotation is available, we
collect data for eight quarters before and after the partner change (including the year of change).
pected earnings. The coefficient on the variable of interest, UE ROTATE is negative (significant at the 0.01 level) in columns
3 and 4 and appears to be economically significant. These findings indicate that in the eyes of short sellers, the informative-
ness of earnings has increased during the post-rotation period relative to the pre-rotation period. In other words, short sell-
ers regard earnings in the post-rotation to be of higher quality. Turning to the control variables, consistent with prior
research, short selling is negatively associated with BMQ and positively associated with TURN. Overall, these findings also
reject the null hypothesis and indicate that short sellers perceive the rotation of the audit partner enhancing audit quality.
5.3. Cost of equity capital
Results of model (3) on the relation between audit partner rotation and cost of equity capital measures are in Table 6. Cost
of equity capital is positively and significantly associated with firm size (SIZEQ), BETA and the standard deviation of BETA. The
coefficient on ROTATE is negative and significant across all columns. In terms of economic significance, the reduction in cost
of equity capital ranges from 80 bps to 150 bps following the audit partner rotation. These findings are consistent with the
notion that investors perceive lower information risk as a result of audit partner rotation. In summary, results from
Tables 4–6 consistently indicate that investors perceive the rotation of the audit partner enhancing audit quality.19
5.4. Robustness tests
5.4.1. Propensity score matching

As the disclosure of audit partner rotation is voluntary, only firms that chose to disclose their rotation of audit partner in
the proxy statement will be identified. It is possible that a firm’s decision to voluntarily disclose audit partner rotation and its
19
While our findings are consistent with Lennox et al. (2014) that mandatory audit partner rotation improves audit quality in the years immediately
surrounding rotation, our results are inconsistent with Litt et al. (2014) who find that financial reporting quality is lower following audit partner change. The
differences in findings between ours and Litt et al. (2014) could be due to differences in research design and sample selection. Litt et al. (2014) identify their
sample by focusing on firms that changed audit firms and state on page 82 ‘‘Our results may not be generalizable to clients that do not change audit firms but
practice audit partner rotation.” They also state that they are unable to directly observe audit partner rotations. Further, they do not examine investors’
perceptions of audit partner rotation.
Table 3
Pearson correlations.
CAR (1,+1) CAR (2,+2) UE ROTATE SIZEQ

Earnings response coefficient test
CAR (-1,+1) 1
CAR (-2,+2) 0.907*** 1
UE 0.323*** 0.334*** 1
ROTATE 0.039 0.056 0.078 1
SIZEQ 0.010 0.013 0.109** 0.081* 1
SI ABSI UE ROTATE SIZEQ LEVQ BMQ MOM TURN INSTQ

Short selling test
SI 1 1
ABSI 0.979***
UE 0.208*** 0.225*** 1
ROTATE 0.061 0.061 0.035 1
SIZEQ 0.523*** 0.488*** 0.059 0.105* 1
LEVQ 0.193*** 0.274*** 0.107* 0.105* 0.051 1
BMQ 0.027 0.092 0.056 0.028 0.157*** 0.299*** 1
MOM 0.062 0.079 0.053 0.042 0.121** 0.054 0.039 1
TURN 0.578*** 0.538*** 0.103* 0.009 0.205*** 0.044 0.343*** 0.057 1
INSTQ 0.099* 0.056 0.169*** 0.084 0.404*** 0.083 0.142** 0.104* 0.108* 1
COEPEG COEOJ COEGLS COEAVE ROTATE SIZEQ LEVQ GROWTH BETA BETASD CASHSD
Cost of equity capital test
COEPEG 1
COEOJ 0.996*** 1 1
COEGLS 0.488*** 0.485***
COEAVE 0.959*** 0.958*** 0.713*** 1
ROTATE 0.141*** 0.136** 0.103* 0.145*** 1
SIZEQ 0.044 0.054 0.291*** 0.133** 0.021 1
LEVQ 0.149*** 0.140*** 0.168*** 0.171*** 0.038 0.072 1
GROWTH 0.078 0.076 0.063 0.082 0.088 0.038 0.090* 1
BETA 0.336*** 0.326*** 0.429*** 0.404*** 0.103* 0.149*** 0.168*** 0.056 1
BETASD 0.139** 0.140*** 0.072 0.135** 0.110** 0.200*** 0.055 0.123** 0.339*** 1
CASHSD 0.089 0.089 0.406*** 0.202** 0.014 0.228*** 0.674*** 0.027 0.056 0.006 1
This table presents the Pearson correlations. Observations are fiscal quarters. For each firm-year observation for which audit partner rotation is available,
we collect data for eight quarters before and after the partner change (including the year of change). ROTATE is an indicator variable that equals 1 for the
audit partner rotation year and the year after and equals 0 for the two years before audit partner rotation. See Appendix B for variable definitions. ***, **, and
* indicate, respectively, statistical significance at the 0.01, 0.05, and 0.10 levels (two-tails).
earnings quality are endogenously determined. Francis et al. (2008) show that firms with good earnings quality have
more expansive voluntary disclosure. Thus, an alternative explanation to our findings is that firms that voluntarily dis-
close audit partner rotation have incentives to improve earnings quality. To mitigate this endogeneity issue, we use
propensity score matching to match each treatment firm (firms that disclosed audit partner rotation) with a control firm
(non-disclosing firms) in the same year, industry, and with a closest propensity score (likelihood of voluntary disclosure
of partner change). Following Francis et al., (2008), we measure the likelihood of voluntary disclosure using the follow-
ing probit model:
PrðDISCLOSEÞ ¼ a0 þ a1 SIZEY þ a2 LEVY þ a3 BMY þ a4 ROAY þ a5 ISSUE þ a6 ANALSTF þ a7 INST þ a8 GEOSEG
þ RIND þ RYD þ e ð7Þ
The dependent variable, DISCLOSE equals 1 for firms that disclosed audit partner rotation and 0 otherwise. Panel A of
Table 7 reports the results of model (7). Consistent with the prior literature, we find larger firms, firms followed by more
analysts, and firms with more institutional shareholdings are more likely to disclose rotation of the audit partner, while firm
complexity is negatively associated with voluntary disclosure. Panel B of Table 7 provides descriptive statistics for treatment
firms and control firms matched on the above attributes. The difference in the mean likelihood (propensity) of voluntary dis-
closure of audit partner change between the treatment firms and control firms is insignificant. Next, we estimate the follow-
ing three models using the matched sample:
CAR ¼ b0 þ b1 UE þ b2 ROTATE þ b3 TREAT þ b4 UE TREAT þ b5 UE ROTATE þ b6 ROTATE TREAT þ b7 UE
ROTATE TREAT þ b8 SIZEQ þ b9 LEVQ þ b10 MBQ þ b11 UE SIZEQ þ b12 UE LEVQ þ b13 UE MBQ
þ RIND þ RYEAR þ e ð8Þ
Table 4
Tests of investors’ perceptions of audit partner rotation on audit quality: earnings response coefficient.
(1) (2) (3) (4)

Variables CAR (1, +1) CAR (2, +2) CAR (1, +1) CAR (2, +2)
UE 1.145*** 1.202*** 3.386*** 1.612***
(0.001) (0.003) (0.000) (0.008)
UE ROTATE 0.740** 0.965**
(0.016) (0.040)
ROTATE 0.002 0.001
(0.779) (0.904)
SIZEQ 0.001 0.001 0.000 0.000
(0.553) (0.568) (0.882) (0.917)
LEVQ 0.057* 0.047 0.069** 0.067*
(0.060) (0.114) (0.028) (0.055)
MBQ 0.001 0.000 0.001 0.001
(0.642) (0.684) (0.140) (0.170)
UE SIZEQ 0.396*** 0.325***
(0.000) (0.000)
UE LEVQ 1.222* 2.571***
(0.090) (0.006)
UE MBQ 0.084*** 0.067***
(0.001) (0.000)
Constant 0.077*** 0.037 0.020 0.052*
(0.000) (0.109) (0.499) (0.054)
Observations 437 437 437 437
R-squared 0.174 0.178 0.247 0.243
This table presents the results of investor perceptions of the effect of audit partner rotation on audit quality (model 1). Observations are fiscal quarters. For
each firm-year observation for which audit partner rotation is available, we collect data for eight quarters before and after the partner change (including the
year of change). UE is abnormal earnings at quarter t scaled by stock price of t 1. Abnormal earnings are the difference between actual earnings per share
and the most recent forecasted earnings per share. ROTATE is an indicator variable that equals 1 for the audit partner rotation year and the year after and
equals 0 for the two years before audit partner rotation. See Appendix B for variable definitions. ***, **, and * indicate, respectively, statistical significance at
the 0.01, 0.05, and 0.10 levels (two-tails). Reported p-value are based on robust standard errors that are clustered by firm and quarter.
SI=ABSI ¼ b0 þ b1 UE þ b2 ROTATE þ b3 TREAT þ b4 UE TREAT þ b5 UE ROTATE þ b6 ROTATE TREAT þ b7 UE

ROTATE TREAT þ b8 SIZEQ þ b9 LEVQ þ b10 MBQ þ b11 RET þ b12 TURN þ b13 INST þ RIND þ RYEAR
þe ð9Þ
COE ¼ b0 þ b1 ROTATE þ b2 TREAT þ b3 ROTATE TREAT þ b4 SIZEQ þ b5 LEVQ þ b6 GROWTH þ b7 BETA

þ b8 BETASD þ b9 CASHSD þ RIND þ RYEAR þ e ð10Þ
TREAT is an indicator variable that equals 1 for treatment firms, and 0 for control firms. Our coefficient of interest in model
(8) and (9) is b7, the coefficient on the three-way interaction term, UE ROTATE TREAT. We expected that the change in
ERC or short seller’s response to earnings after audit partner rotation is significantly stronger in treatment firms than control
firms. That is, b7 is expected to be positive and significant in model (8) and negative and significant in model (9). Our variable
of interest in model (10) is b3. A negative and significant b3 will be consistent with the notion that the decrease in cost of
equity after audit partner rotation is significantly stronger for treatment firms than for control firms.
Results of model (8), (9) and (10) are presented in Panel C (earnings response coefficient), D (short selling), and E (cost of
equity capital) of Table 7. Consistent with our prediction, we find that the coefficient on UE ROTATE TREAT is positive and
significant in model (7), and negative and significant in model (8). These findings suggest that improvement in ERC and short
sellers’ response to earnings after audit partner rotation is higher in treatment firms compared to control firms. Results in
Panel E shows that the coefficient on ROTATE TREAT is negative and significant in three of the four model specifications,
indicating that compared to the control firms, the treatment firms experience significantly greater decrease in cost of equity
after the rotation of audit partner. Overall, these results mitigate the concern that our findings are confounded by endogene-
ity issue associated with firms’ decision to voluntarily disclose rotation of the audit partner.20
5.4.2. Placebo test

Another concern with our tests is that our findings could potentially be driven by some time-varying factors that are
unrelated to audit partner change. The ideal way to alleviate this concern is to identify a group of comparable firms with
no audit partner change and show that there is no significant change in the measures of perceived audit quality after the
20
As an alternate to one-to-one matching of treatment and control firms, we employ entropy balancing, a weighting technique that uses all control firms, i.e.,
we match each treatment firm with multiple control firms. Untabulated results indicate that the coefficient on UEROTATETREAT is positive (negative) and
significant at the 0.05 (0.01) level in the earnings response coefficient (short selling) model. Turning to cost of equity models, the coefficient on ROTATETREAT
is negative and significant at the 0.05 level for all measures except COEGLS. These results are consistent with the results based on one-to-one matching.
Table 5
Tests of investors’ perceptions of audit partner rotation on audit quality: short selling.
(1) (2) (3) (4)

Variables Short interest Abnormal short interest Short interest Abnormal short interest
UE 0.454** 0.506*** 0.244** 0.261***
(0.017) (0.007) (0.045) (0.009)
UE ROTATE 1.184*** 1.378***
(0.001) (0.001)
ROTATE 0.003 0.004
(0.661) (0.609)
SIZEQ 0.005 0.006 0.005 0.006*
(0.196) (0.132) (0.158) (0.098)
LEVQ 0.066 0.074 0.056 0.063
(0.226) (0.209) (0.269) (0.250)
BMQ 0.057** 0.046* 0.054** 0.043*
(0.018) (0.075) (0.019) (0.080)
RET 0.011 0.009 0.017 0.016
(0.535) (0.601) (0.440) (0.475)
INSTQ 0.020 0.020 0.012 0.010
(0.404) (0.498) (0.595) (0.705)
TURN 0.357*** 0.328*** 0.356*** 0.326***
(0.000) (0.002) (0.000) (0.002)
Constant 0.003 0.023 0.007 0.011
(0.954) (0.687) (0.874) (0.830)
Industry FE yes yes yes yes
Year FE yes yes yes yes
R-squared 0.690 0.664 0.703 0.681
This table presents the results of investor (short sellers) perceptions of the effect of audit partner rotation on audit quality (model 2). Observations are fiscal
quarters. For each firm-year observation for which audit partner rotation is available, we collect data for eight quarters before and after the partner change
(including the year of change). Short interest is the number of stock-split-adjusted shares shorted, scaled by the number of outstanding shares in the month
when quarterly earnings were announced. Abnormal short interest is estimated after controlling for firm size, book-to-market and return momentum in the
month when quarterly earnings were announced. UE is abnormal earnings at quarter t scaled by stock price of t 1. Abnormal earnings are the difference
between actual earnings per share and the most recent forecasted earnings per share. ROTATE is an indicator variable that equals 1 for the audit partner
rotation year and the year after and equals 0 for the two years before audit partner rotation. See Appendix B for variable definitions. ***, **, and * indicate,
respectively, statistical significance at the 0.01, 0.05, and 0.10 levels (two-tails). Reported p-value are based on robust standard errors that are clustered by
firm and quarter.
Table 6
Tests of investors’ perceptions of audit partner rotation on audit quality: cost of equity.
(1) (2) (3) (4)

Variables COEPEG COEOJ COEGLS COEAVE
ROTATE 0.015** 0.015** 0.008** 0.577***
(0.024) (0.028) (0.011) (0.008)
SIZEQ 0.004 0.004 0.008*** 0.265***
(0.151) (0.136) (0.000) (0.004)
LEVQ 0.092* 0.090* 0.018 2.295
(0.063) (0.071) (0.533) (0.187)
GROWTH 0.068 0.073 0.085* 3.498
(0.500) (0.478) (0.070) (0.271)
BETA 0.053*** 0.051*** 0.050*** 2.358***
(0.000) (0.001) (0.000) (0.000)
BETASD 0.126*** 0.119** 0.032 4.069**
(0.006) (0.015) (0.270) (0.012)
CASHSD 0.313 0.315 0.310 3.607
(0.361) (0.359) (0.149) (0.783)
Constant 0.087** 0.080** 0.014 6.808***
(0.032) (0.049) (0.554) (0.000)
R-squared 0.335 0.321 0.599 0.422
This table presents the results of the relation between audit partner rotation and cost of equity (model 3). Observations are fiscal quarters. For each firm-
year observation for which audit partner rotation is available, we collect data for eight quarters before and after the partner change (including the year of
change). COEPEG, COEOJ, and COEGLS are measures of cost of equity capital based on Easton (2004), Ohlson and Juettner-Nauroth (2005), and Gebhardt et al.
(2001), respectively. ROTATE is an indicator variable that equals 1 for the audit partner rotation year and the year after and equals 0 for the two years before
audit partner rotation. See Appendix B for variable definitions. ***, **, and * indicate, respectively, statistical significance at the 0.01, 0.05, and 0.10 levels
(two-tails). Reported p-value are based on robust standard errors that are clustered by firm and quarter.
Table 7
Tests of investors’ perceptions of audit partner rotation on audit quality: Propensity score matched-sample.
(1)
Variables Disclosure
Panel A: Probit model on the likelihood of voluntary disclosure
SIZEY 0.066***
(0.005)
LEVY 0.024
(0.868)
BMY 0.053
(0.227)
ROAY 0.490
(0.369)
ISSUE 0.571
(0.507)
ANALSTF 0.030***
(0.000)
INST 0.017**
(0.020)
GEOSEG 0.184*
(0.081)
Industry FE yes
Year FE yes
Constant 9.100***
(0.000)
Observations 71,295
Pseudo R2 0.189
Treat Control
Variables N Mean Median N Mean Median Mean difference
Panel B: Descriptive statistics for treatment firms and control firms
Propensity 45 2.648 2.819 45 2.935 2.856 0.287
SIZEY 45 8.493 8.744 45 8.482 8.458 0.011
LEVY 45 0.591 0.624 45 0.655 0.608 0.064
BMY 45 0.620 0.475 45 0.636 0.513 0.016
ROAY 45 0.052 0.041 45 0.061 0.028 0.113
ISSUE 45 0.632 1.000 45 0.605 1.000 0.026
ANALSTF 45 13.300 8.750 45 14.996 13.208 1.695
INST 45 0.603 0.664 45 0.529 0.593 0.073
GEOSEG 45 2.868 2.000 45 4.474 1.000 1.605
(1) (2)
Variables CAR (1, +1) CAR (2, +2)
Panel C: Earnings response coefficient
UE 0.828* 0.807*
(0.098) (0.079)
ROTATE 0.012* 0.014**
(0.095) (0.028)
TREAT 0.008* 0.012**
(0.060) (0.021)
UE TREAT 0.170 0.056
(0.758) (0.898)
UE ROTATE 0.462 0.343
(0.210) (0.393)
ROTATE TREAT 0.010 0.013
(0.311) (0.153)
UE ROTATE TREAT 1.460*** 1.712***
(0.008) (0.001)
SIZEQ 0.001 0.000
(0.516) (0.787)
LEV 0.002 0.006
(0.928) (0.749)
MBQ 0.000 0.000
(0.642) (0.655)
UE SIZEQ 0.034*** 0.037***
(0.000) (0.000)
UE LEVQ 0.097 0.017
(0.892) (0.981)
UE MBQ 0.021 0.030
(0.775) (0.705)
(continued on next page)

Constant 0.018 0.043

(0.436) (0.153)
Industry FE yes yes
Year FE yes yes
Observations 899 899
R-squared 0.145 0.144
This table presents the results of investor perceptions of the effect of audit partner rotation on audit quality after including control firms (model 8).
Observations are fiscal quarters. UE is abnormal earnings at quarter t scaled by stock price of t 1. Abnormal earnings are the difference between
actual earnings per share and the most recent forecasted earnings per share. ROTATE is an indicator variable that equals 1 for the audit partner rotation
year and the year after and equals 0 for the two years before audit partner rotation. See Appendix B for variable definitions. ***, **, and * indicate,
respectively, statistical significance at the 0.01, 0.05, and 0.10 levels (two-tails). Reported p-value are based on robust standard errors that are
clustered by firm and quarter.
(1) (2)
Variables Short interest Abnormal short interest
Panel D: Short selling
UE 0.035 0.108
(0.688) (0.121)
ROTAT 0.010* 0.008
(0.088) (0.157)
TREAT 0.000 0.000
(0.956) (0.984)
UE TREAT 0.347** 0.403***
(0.040) (0.008)
UE ROTATE 0.058 0.160**
(0.521) (0.037)
ROTATE TREAT 0.009 0.009
(0.373) (0.430)
UE ROTATE TREAT 1.381*** 1.472***
(0.001) (0.002)
SIZEQ 0.007*** 0.008***
(0.000) (0.000)
LEVQ 0.018 0.024
(0.583) (0.473)
BMQ 0.015* 0.003
(0.083) (0.729)
MOM 0.003 0.003
(0.818) (0.802)
INSTQ 0.017 0.008
(0.329) (0.627)
TURN 0.232*** 0.217***
(0.000) (0.000)
Constant 0.051* 0.027
(0.070) (0.332)
Industry FE yes yes
Year FE yes yes
R-squared 0.601 0.586
This table presents the results of investor (short sellers) perceptions of the effect of audit partner rotation on audit quality after including the control
firms (model 9). Observations are fiscal quarters. Short interest is the number of stock-split-adjusted shares shorted, scaled by the number of
outstanding shares in the month when quarterly earnings were announced. Abnormal short interest is estimated after controlling for firm size, book-
to-market and return momentum in the month when quarterly earnings were announced. UE is abnormal earnings at quarter t scaled by stock price of
t 1. Abnormal earnings are the difference between actual earnings per share and the most recent forecasted earnings per share. ROTATE is an
indicator variable that equals 1 for the audit partner rotation year and the year after and equals 0 for the two years before audit partner rotation. See
Appendix B for variable definitions. ***, **, and * indicate, respectively, statistical significance at the 0.01, 0.05, and 0.10 levels (two-tails). Reported p-
value are based on robust standard errors that are clustered by firm and quarter.
(1) (2) (3) (4)
VARIABLES COEPEG COEOJ COEGLS COEAVE
Panel E: Cost of equity
ROTATE 0.001 0.001 0.001 0.019
(0.321) (0.812) (0.816) (0.849)
ROTATE TREAT 0.011** 0.010* 0.005 0.506**
(0.039) (0.050) (0.278) (0.038)
TREAT 0.001 0.001 0.007 0.098
(0.904) (0.871) (0.100) (0.727)
SIZEQ 0.001 0.001 0.003*** 0.102*
(0.672) (0.450) (0.003) (0.089)
LEVQ 0.064** 0.065** 0.003 2.583*
(0.025) (0.021) (0.894) (0.070)
GROWTH 0.005 0.006 0.016 0.105
(0.916) (0.894) (0.245) (0.959)
Table 7 (continued)
BETA 0.034*** 0.034*** 0.031*** 2.001***

(0.002) (0.002) (0.000) (0.000)
BETASD 0.066*** 0.065** 0.025 3.260**
(0.008) (0.011) (0.148) (0.011)
CASHSD 0.265 0.246 0.244* 5.313
(0.222) (0.257) (0.096) (0.613)
Constant 0.046** 0.053*** 0.046*** 2.405***
(0.024) (0.008) (0.000) (0.003)
R-squared 0.366 0.364 0.621 0.454
This table presents the results of the relation between audit partner rotation and cost of equity after including the control firms (model 10). Observations
are fiscal quarters. COEPEG, COEOJ, and COEGLS are measures of cost of equity capital based on Easton (2004), Ohlson and Juettner-Nauroth (2005), and
Gebhardt et al. (2001), respectively. ROTATE is an indicator variable that equals 1 for the audit partner rotation year and the year after and equals 0 for the
two years before audit partner rotation. See Appendix B for variable definitions. ***, **, and * indicate, respectively, statistical significance at the 0.01,
0.05, and 0.10 levels (two-tails). Reported p-value are based on robust standard errors that are clustered by firm and quarter.
rotation for this sample of control firms. However, since the information on audit partner change is not disclosed mandato-
rily, it is challenging to identify firms that did not change audit partner. Therefore, we conduct a placebo test to rule out the
above concern. As firms are unlikely to rotate audit partner very frequently, it is reasonable to assume that there is no audit
partner rotation in years shortly before the rotation year. Therefore, for each of our rotation observation, we assign a ‘‘pseudo
rotation year” which is two years before the actual rotation year. Next, we examine whether there is a change in perceived
audit quality between the two years before the pseudo rotation year and two years after (including the pseudo rotation
year). If our empirical results are mainly driven by time trend, then we would observe a similar change in perceived audit
quality around the pseudo rotation year. Untabulated results indicate that the coefficient on UE ROTATE is not significant in
the earnings response coefficient model and the short selling model. Similarly, the coefficient on ROTATE is not significant in
the cost of equity model. Overall, these results provide some assurance that our results are not due to some time-varying
factors that are unrelated to audit partner change.
5.5. Additional analyses
Next, we examine whether the rotation of the audit partner is associated with improvements in audit quality. A universal
measure of audit quality currently does not exist and therefore we use multiple measures to infer audit quality (DeFond and
Zhang, 2014). Further, use of multiple measures enhances the robustness of our findings. We use three measures of audit
quality. First is earnings persistence i.e., the association between current earnings and future earnings.21 Managers and ana-
lysts regard earnings persistence as an important attribute of earnings. Our second measure is predictive ability of earnings for
future cash flows. Ability of earnings to predict future cash flows is a fundamental objective of financial reporting.22 Further,
forecasting future cash flows plays a key role in economic models of equity value (Barth et al., 2012). Consistent with prior
research, we interpret higher values of earnings persistence and earnings predictability as evidence of higher audit quality
(Johnson et al., 2002). Our third measure is the likelihood of meeting or beating earnings benchmarks. We use three measures
of earnings benchmarks: small earnings, small change in earnings, and earnings forecast error. A higher likelihood of meeting or
beating earnings benchmarks is consistent with lower audit quality.
We first describe empirical models used to test the relation between audit partner rotation and audit quality. We estimate
the following models to test persistence of earnings and earnings predictability of future cash flows:
EPSPOST ¼ b0 þ b1 EPS þ b2 EPS ROTATE þ b3 ROTATE þ RIND þ RYEAR þ e ð11Þ
OCFPOST ¼ b0 þ b1 EPS þ b2 EPS ROTATE þ b3 ROTATE þ RIND þ RYEAR þ e ð12Þ
where EPSPOST is the earnings per share of quarter i in fiscal year t + 1, and EPS is the earnings per share of quarter i in fiscal
year t. OCFPOST is the operating cash flow per share of quarter i in fiscal year t + 1. Consistent with prior research, b1 is pre-
dicted to be positive in models (11) and (12). ROTATE is an indicator variable that equals 1 for the audit partner rotation year
and the year after and equals 0 for the two years before rotation of the audit partner. We also include industry and year fixed
effects in the models to control for industry and year-specific factors. To mitigate concerns about potential cross-sectional
21
We realize that earnings persistence is also commonly used in accounting research as a measure of earnings quality (Schipper and Vincent, 2003; Dechow
and Schrand, 2004). Financial statements are a joint product of managers and auditors and we follow concurrent audit research that views earnings quality as
an outcome of audit quality (see Knechel et al., 2013 for a review). Given the smaller sample size, our goal is to use measures that can be estimated for our
sample. Therefore, we do not use going concern opinions or restatements to measure audit quality.
22
Statement of Financial Accounting Concepts No. 1 (FASB, 1978) states that information about earnings should be helpful to users in assessing the amounts,
timing, and uncertainty of future cash flows.
correlation across firms or across time, in all our models we rely on robust standard errors that are clustered by firm and by
quarter. If audit quality has improved after the rotation of the lead audit partner, we expect b2 to be positive in both models.
On the other hand, a negative coefficient on b2 would be consistent with a decline in audit quality following rotation of the
audit partner.
We use the following logit model to test whether the rotation of the lead audit partner has changed firms’ propensity to
meet/beat the three earnings benchmarks:
BEAT ¼ b0 þ b1 ROTATE þ b2 SIZEQ þ b3 LEVQ þ b4 CASHQ þ b5 MBQ þ RIND þ RYEAR þ e ð13Þ
BEAT equals one of the following measures: BEATZERO, BEATZEROCH, and BEATANALST (see the Appendix B for variable def-
initions). We define firms as just beating the zero earnings benchmark (zero change in earnings benchmark) if the quarterly
net income (change in quarterly net income) scaled by total assets is greater than or equal to zero but less than 0.005. Sim-
ilarly, suspects of just beating analysts’ forecast are those firms whose forecast error (the difference between actual earnings
and analysts’ consensus forecast) is greater than or equal to zero but less than 0.05. We expect b1 to be negative (positive), if
the rotation of the lead audit partner indeed improves (impairs) audit quality and mitigates firms’ propensity to manage
earnings to meet or beat earnings benchmarks. Last, we include a vector of controls that are known to be associated with
firms’ likelihood of meeting or beating earnings benchmarks. First, we control for firm size, SIZEQ, because the prior literature
(Barton and Simko, 2002; Matsumoto, 2002) has found that firm size is positively related to meeting/beating earnings tar-
gets. We also include leverage ratio, LEVQ, because Chevis et al. (2002) find that firms with higher leverage are more inclined
to meet/beat earnings benchmarks. To control for firms’ performance, we add cash flow ratio, CASHQ, in the model. Finally,
firms with high growth prospect are under greater pressure to meet/beat earnings targets (Skinner and Sloan, 2002). There-
fore, we include the market to book ratio, MBQ.
5.5.1. Audit partner rotation and earnings persistence

Panel A of Table 8 reports the statistics for variables in models (11), (12), and (13)23. About 16.7% of the sample report
scaled quarterly earnings in the 0–0.005 range, consistent with earnings benchmark beating. Similarly, about 35.6% of the sam-
ple report scaled change in quarterly earnings in the 0–0.005 range. Results of model (11) on the effect of audit partner rotation
on earnings persistence are in Panel B, Table 8. We present the results for the full sample (column 1 and 2) as well as sub-
samples partitioned on firm size (columns 3 and 4) and analyst following (columns 5 and 6). The sub-sample analyses are moti-
vated to provide empirical evidence on contexts where audit partner rotation has a greater effect on audit quality.24 The coef-
ficient on EPS is positive and significant at the 0.01 level across all columns, indicating persistence of earnings. The coefficient on
ROTATE is not significant except in column 6. The coefficient on the variable of interest, EPS ROTATE is positive but not signif-
icant for the full sample. However, it is (0.379) significant at the 0.05 level for small firms and significant at the 0.01 level for
firms followed by fewer analysts. These findings indicate that earnings persistence has increased by about 90% (147%) for smal-
ler firms (firms followed by fewer analysts) during the post-rotation period relative to the pre-rotation period.25 Overall, the
above results are consistent with the notion that audit partner rotation has a favorable effect on audit quality for smaller firms
and firms that are followed by fewer analysts.
5.5.2. Audit partner rotation and earnings predictability

Panel C reports the results of model (12) on the predictability of earnings for next period cash flows. The coefficient on EPS
is positive and significant at the 0.01 level across all columns, indicating that current period earnings are associated with
next period cash flows, consistent with prior research. The coefficient on the variable of interest, EPS ROTATE is 0.485
and significant at the 0.10 level for small firms and 0.257 (significant at the 0.01 level) for firms followed by fewer analysts.
These findings indicate that the predictive value of earnings for future cash flows has increased by about 85% (31%) for smal-
ler firms (firms followed by fewer analysts) during the post-rotation period relative to the pre-rotation period. These results
are consistent with the results in Panel B.
5.5.3. Audit partner rotation and meeting or beating earnings benchmarks

Results of our third audit quality measure are in Panel D. We present the results in three columns: meeting or beating
zero scaled quarterly earnings, meeting or beating zero scaled change in quarterly earnings, and meeting or beating analysts’
23
The number of observation is smaller for earnings persistence test because we exclude the year before the rotation year.
24
Prior research finds that smaller firms are at greater risk of fraud due to ineffective or a lack of internal controls relative to larger firms (ACFE 2012).
Consistent with this notion, Kinney and McDaniel (1989) find that firms that correct previously reported quarterly earnings are smaller than non-correcting
firms. Similarly, Scholz (2014) finds that firms that restate are smaller than COMPUSTAT firms. Further, firms that announce ‘‘4.02” restatements (more serious
restatements disclosed on Form 8-K item 4.02) tend to be smaller than non-4.02 firms. Prior research also finds that financial analyst following has implications
for audit quality. Analysts act as external monitors of management and thus, analysts following enhances transparency of a firm’s accounting information.
Consistent with this notion, Yu (2008) finds that firms followed by more analysts manage their earnings less. Gotti et al. (2012) argue that analyst following
mitigates opportunistic earnings management and thus, mitigates audit risk. Therefore, we examine whether the relation between audit partner rotation and
audit quality is conditional on firm size and analyst following. We partition the sample at the mean value of total assets and code observations above (below)
the mean as large (small) firms. Similarly, we partition at the mean value of the number of analysts following and code observations above (below) the mean as
more (fewer) analysts following.
25
The increase in earnings persistence for smaller firms = 0.379/0.421 = 90%.
Table 8
Tests of the relation between audit partner rotation and audit quality.
Variable N Mean Median SD P25 P75

Panel A: Descriptive statistics
Earnings persistence
EPSPOST 442 0.473 0.421 0.786 0.130 0.823
EPS 442 0.490 0.417 0.818 0.140 0.793
ROTATE 442 0.572 1.000 0.495 0.000 1.000
Earnings predictability of future cash flows
OCFPOST 619 1.003 0.755 2.029 0.234 1.398
EPS 619 0.467 0.412 0.814 0.122 0.806
ROTATE 619 0.414 0.000 0.493 0.000 1.000
Meeting or beating earnings benchmarks
BEATZERO 635 0.167 0.000 0.373 0.000 0.000
BEATZEORCH 634 0.356 0.000 0.479 0.000 1.000
BEATANALST 549 0.197 0.000 0.398 0.000 0.000
ROTATE 635 0.471 0.000 0.500 0.000 1.000
SIZEQ 635 8.565 8.863 2.508 7.093 10.344
LEVQ 635 0.620 0.629 0.210 0.453 0.777
CASHQ 635 0.045 0.039 0.073 0.012 0.082
MBQ 635 3.850 2.230 6.416 1.229 3.671
Full sample Large firms Small firms Firms followed by more analysts Firms followed by fewer analysts
(1) (2) (3) (4) (5) (6)
Panel B: Earnings persistence
VARIABLES EPSPOST EPSPOST EPSPOST EPSPOST EPSPOST EPSPOST
EPS 0.674*** 0.579*** 0.741*** 0.421*** 0.923*** 0.371***
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
EPS ROTATE 0.175 0.221 0.379** 0.443 0.547***
(0.418) (0.588) (0.028) (0.217) (0.000)
ROTATE 0.166 0.109 0.135 0.319 0.294**
(0.232) (0.752) (0.403) (0.240) (0.013)
Constant 0.113 0.154 0.008 0.205** 0.322 0.026
(0.591) (0.510) (0.979) (0.044) (0.465) (0.819)
Industry FE yes yes yes yes yes yes
Year FE yes yes yes yes yes yes
Observations 442 442 233 209 205 237
R-squared 0.575 0.584 0.469 0.648 0.534 0.688
This table presents the results of the relation between audit partner rotation and earnings persistence (model 11). Observations are fiscal quarters. For
each firm-year observation for which audit partner rotation is available, we collect data for eight quarters before and after the partner change
(including the year of change). EPSPOST is earnings per share at quarter i of year t + 1. EPS is earnings per share at quarter i of year t. ROTATE is an
indicator variable that equals 1 for the audit partner rotation year and the year after and equals 0 for the two years before audit partner rotation. We
partition the sample at the mean value of total assets and code observations above (below) the mean as large (small) firms. Similarly, we partition at
the mean value of the number of analysts following and code observations above (below) the mean as more (fewer) analysts following. See Appendix
B for variable definitions. ***, **, and * indicate, respectively, statistical significance at the 0.01, 0.05, and 0.10 levels (two-tails). Reported p-value are
based on robust standard errors that are clustered by firm and quarter.
Full sample Large firms Small firms Firms followed by more analysts Firms followed by fewer analysts
(1) (2) (3) (4) (5) (6)
Panel C: Earnings predictability of future cash flows
VARIABLES OCFPOST OCFPOST OCFPOST OCFPOST OCFPOST OCFPOST
EPS 1.017*** 0.986*** 1.160*** 0.571*** 1.145*** 0.842***
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
EPS ROTATE 0.079 0.116 0.485* 0.050 0.257***
(0.679) (0.798) (0.083) (0.908) (0.004)
ROTATE 0.104 0.127 0.254* 0.169 0.219*
(0.313) (0.664) (0.052) (0.465) (0.058)
Constant 1.207** 1.289** 1.291*** 0.237*** 0.446* 1.724***
(0.031) (0.029) (0.006) (0.000) (0.052) (0.000)
Observations 619 619 333 286 290 329
R-squared 0.207 0.207 0.150 0.199 0.190 0.256
This table presents the results of the relation between audit partner rotation and earnings predictability (model 12). Observations are fiscal quarters.
For each firm-year observation for which audit partner rotation is available, we collect data for eight quarters before and after the partner change
(including the year of change). OCFPOST is operating cash flow per share at quarter i of year t + 1. EPS is earnings per share at quarter i of year t. ROTATE
is an indicator variable that equals 1 for the audit partner rotation year and the year after and equals 0 for the two years before audit partner rotation.
We partition the sample at the mean value of total assets and code observations above (below) the mean as large (small) firms. Similarly, we partition
at the mean value of the number of analysts following and code observations above (below) the mean as more (fewer) analysts following. See
Appendix B for variable definitions. ***, **, and * indicate, respectively, statistical significance at the 0.01, 0.05, and 0.10 levels (two-tails). Reported p-
value are based on robust standard errors that are clustered by firm and quarter.
(1) (2) (3)

VARIABLES BEATZERO BEATZEROCH BEATANALST
Panel D: Meeting or beating earnings benchmarks
ROTATE 0.499 0.077 0.344
(0.240) (0.766) (0.260)
SIZEQ 0.259* 0.194*** 0.161
(0.087) (0.001) (0.290)
LEVQ 9.343*** 0.124 0.379
(0.009) (0.895) (0.785)
CASHQ 2.268 4.869*** 2.681
(0.769) (0.003) (0.215)
MBQ 0.437 0.013 0.002
(0.149) (0.777) (0.977)
Constant 8.132*** 2.914*** 2.474
(0.000) (0.000) (0.101)
Industry FE Yes Yes Yes
Year FE Yes Yes Yes
Observations 635 634 549
Log likelihood 138.75 381.26 251.45
This table presents the results of the relation between audit partner rotation and beating of earnings benchmarks (model 13). Observations are fiscal
quarters. For each firm-year observation for which audit partner rotation is available, we collect data for eight quarters before and after the partner
change (including the year of change). BEATZERO is an indicator variable that equals 1 if the quarterly earnings scaled by total assets is large than or
equal to zero but less than 0.005, 0 otherwise. BEATZEROCH is an indicator variable that equals 1 if the change in quarterly earnings scaled by total
assets is larger than or equal to zero but less than 0.005, 0 otherwise. BEATANALST is an indicator variable that equals 1 if the quarterly earnings
forecasted error is larger than or equal to zero but less than 0.05, 0 otherwise. ROTATE is an indicator variable that equals 1 for the audit partner
rotation year and the year after and equals 0 for the two years before audit partner rotation. See Appendix B for variable definitions. ***, **, and *
indicate, respectively, statistical significance at the 0.01, 0.05, and 0.10 levels (two-tails). Reported p-value are based on robust standard errors that are
Large firms Small firms

(1) (2) (3) (4) (5) (6)
VARIABLES BEATZERO BEATZEROCH BEATANALST BEATZERO BEATZEROCH BEATANALST
Panel E: Meeting or beating earnings benchmarks: large vs. small firms
ROTATE 0.035 0.025 0.710 1.405*** 0.164 0.295
(0.962) (0.941) (0.149) (0.003) (0.753) (0.474)
SIZEQ 0.201 0.062 0.272 0.095 0.466*** 0.026
(0.589) (0.541) (0.154) (0.493) (0.006) (0.951)
LEVQ 13.965** 0.469 1.873 5.161 1.248 0.320
(0.017) (0.782) (0.349) (0.231) (0.337) (0.876)
CASHQ 1.432 4.357 1.020 5.219 4.072** 4.336
(0.952) (0.105) (0.781) (0.449) (0.027) (0.109)
MBQ 0.211 0.024 0.073 0.584* 0.010 0.086
(0.265) (0.613) (0.570) (0.096) (0.895) (0.114)
Constant 12.849** 2.053 2.632 4.253 2.975*** 2.370
(0.041) (0.177) (0.247) (0.204) (0.009) (0.432)
Industry FE Yes Yes Yes Yes Yes Yes
Year FE Yes Yes Yes Yes Yes Yes
Observations 337 337 322 298 297 227
Log likelihood 65.83 211.03 145.95 58.21 154.41 87.21
This table presents the results of the relation between audit partner rotation and beating of earnings benchmarks (model 13) for firms partitioned on
the mean value of firm size. Observations are fiscal quarters. For each firm-year observation for which audit partner rotation is available, we collect
data for eight quarters before and after the partner change (including the year of change). BEATZERO is an indicator variable that equals 1 if the
quarterly earnings scaled by total assets is large than or equal to zero but less than 0.005, 0 otherwise. BEATZEROCH is an indicator variable that equals
1 if the change in quarterly earnings scaled by total assets is larger than or equal to zero but less than 0.005, 0 otherwise. BEATANALST is an indicator
variable that equals 1 if the quarterly earnings forecasted error is larger than or equal to zero but less than 0.05, 0 otherwise. ROTATE is an indicator
variable that equals 1 for the audit partner rotation year and the year after and equals 0 for the two years before audit partner rotation. See Appendix B
for variable definitions. ***, **, and * indicate, respectively, statistical significance at the 0.01, 0.05, and 0.10 levels (two-tails). Reported p-value are
based on robust standard errors that are clustered by firm and quarter.
Firm followed by more analysts Firms followed by fewer analysts
(1) (2) (3) (4) (5) (6)
Panel F: Meeting or beating earnings benchmarks: firms followed by more vs. fewer analysts
ROTATE 0.381 0.145 0.506 1.248** 0.112 0.349
(0.704) (0.708) (0.291) (0.027) (0.796) (0.386)
SIZEQ 0.720 0.209 0.205 0.328*** 0.364*** 0.390
(0.165) (0.130) (0.413) (0.005) (0.000) (0.177)
LEVQ 22.782*** 1.028 1.465 6.750** 1.475 0.080
(0.000) (0.627) (0.518) (0.027) (0.203) (0.969)
Table 8 (continued)
CASHQ 13.201 7.289*** 1.344 10.295 2.537* 2.837

(0.301) (0.000) (0.634) (0.284) (0.099) (0.409)
MBQ 0.398** 0.022 0.165 0.539 0.087 0.156
(0.027) (0.760) (0.115) (0.165) (0.275) (0.247)
Constant 26.419*** 3.928*** 1.782 6.392*** 2.914*** 4.824*
(0.000) (0.005) (0.358) (0.004) (0.000) (0.059)
Observations 306 306 306 329 328 243
Log likelihood 40.21 182.08 135.57 76.58 182.93 99.51
This table presents the results of the relation between audit partner rotation and beating of earnings benchmarks (model 13) for firms partitioned on
the mean value of the number of analysts following. Observations are fiscal quarters. For each firm-year observation for which audit partner rotation
is available, we collect data for eight quarters before and after the partner change (including the year of change). BEATZERO is an indicator variable that
equals 1 if the quarterly earnings scaled by total assets is large than or equal to zero but less than 0.005, 0 otherwise. BEATZEROCH is an indicator
variable that equals 1 if the change in quarterly earnings scaled by total assets is larger than or equal to zero but less than 0.005, 0 otherwise.
BEATANALST is an indicator variable that equals 1 if the quarterly earnings forecasted error is larger than or equal to zero but less than 0.05, 0
otherwise. ROTATE is an indicator variable that equals 1 for the audit partner rotation year and the year after and equals 0 for the two years before
audit partner rotation. See Appendix B for variable definitions. ***, **, and * indicate, respectively, statistical significance at the 0.01, 0.05, and 0.10
levels (two-tails). Reported p-value are based on robust standard errors that are clustered by firm and quarter.
forecasts. As before, we partition firms on size and analyst following and those results are in Panels E and F, respectively.
Results in Panel D indicate that the coefficient on ROTATE is not significant in all 3 columns. Results in Panels E and F indicate
that the likelihood of meeting or beating small earnings is significantly lower in the post rotation period relative to the pre-
rotation period for small firms or firms followed by fewer analysts (significant at the 0.01 and 0.05 level). The magnitudes of
the marginal effects suggest that the likelihood of meeting or beating small earnings is lower by about 2.58% for smaller
firms and 4.96% for firms followed by fewer analysts during the post-rotation period. These results are consistent with
the results in Panels B and C. Overall, results in Table 8 provide some support for the notion that rotation of the audit partner
is associated with an increase in audit quality for smaller firms and firms followed by fewer analysts.
5.5.4. Effects of audit partner rotation for more complex firms

Finally, we examine the effect of audit partner rotation on firms that are more complex relative to other firms. This anal-
ysis is motivated by the conjecture that the learning costs are quite significant in firms that are complex and thus the poten-
tial for information asymmetry between the client and the audit partner as well as the loss of client-specific expertise due to
partner change are greater for these firms. These concerns are less likely to significantly impact audit quality for less complex
firms. We partition observations based on the number of geographic segments and firm size and code observations in the top
quartile of each partition as more complex observations.26 We reestimate models (11), (12), and (13) for these sub-samples
and the results are in Table 9. Results in Panel A indicate that the coefficient on the variable of interest, EPS ROTATE is negative
and significant at the 0.01 level in both columns, indicating that earnings persistence has decreased for more complex firms
during the post-rotation period relative to the pre-rotation period. Similarly, results in Panel B indicate that the predictive value
of earnings for future cash flows has decreased for more complex firms during the post-rotation period (significant at the 0.05
and 0.01 levels, respectively, in columns 1 and 2). Finally, the coefficient on ROTATE is negative and significant in Panel C when
complexity is based on the number of geographic segments but not when complexity is based on firm size, suggesting that the
propensity to meet or beat zero earnings and analyst forecast are lower for more complex firms. Overall, we find some evidence
that audit partner rotation has an adverse effect on audit quality for more complex firms.27
6. Conclusion
Though rules calling for rotation of the audit partner have been in vogue in the U.S. for a long time, there is only limited
research on the costs and benefits of audit partner rotation. In particular, we do not know whether users of financial state-
ments, i.e., equity market participants value audit partner rotation. This is an important issue since many in the auditing pro-
fession believe that mandatory rotation of the audit partner is unnecessary and may in fact impair audit quality. We
26
Note in Table 8 we partition observations at the mean value of total assets and code observations above (below) the mean as large (small) firms. In Table 9,
we retain only those observations in the top quartile based on the number of geographic segments and firm size.
27
We also repeat these analyses for less complex firms. When we code firms in the bottom quartile of the number of geographic segments and firm size, the
effect of audit partner rotation on audit quality is not significant, possibly due to the small sample size. When we code observations in the bottom three
quartiles as less complex firms, we find that audit partner rotation has a favorable effect on audit quality. We also conduct tests of investor perceptions on sub-
samples of more complex firms that those results indicate that audit partner rotation is not significantly associated with earnings informativeness, short selling,
and cost of equity.
Table 9
Tests of the relation between audit partner rotation and audit quality for complex firms.
More complex Firms (based on geographic segment) More complex Firms (based on firm size)
(1) (2)
VARIABLES EPSPOST EPSPOST
Panel A: Earnings persistence
EPS 0.642*** 0.968***
(0.000) (0.000)
EPS ROTATE 0.667*** 1.138***
(0.006) (0.001)
ROTATE 0.534 0.714*
(0.125) (0.055)
Constant 0.061 0.167
(0.662) (0.639)
R-squared 0.463 0.423
(1) (2)
VARIABLES OCFPOST OCFPOST
Panel B: Earnings predictability of future cash flows
EPS 0.321* 0.861***
(0.068) (0.000)
EPS ROTATE 0.376** 0.943***
(0.011) (0.000)
ROTATE 0.006 0.020
(0.370) (0.144)
Constant 0.011 0.025***
(0.313) (0.001)
R-squared 0.628 0.162
(1) (2) (3) (4) (5) (6)
Panel C: Meeting or beating earnings benchmarks
ROTATE 2.504** 1.285* 1.333* 1.634 0.733 0.563
(0.050) (0.075) (0.079) (0.294) (0.159) (0.458)
SIZEQ 0.412 0.249 14.609*** 0.457 0.089 0.523*
(0.507) (0.366) (0.000) (0.363) (0.288) (0.057)
LEVQ 0.965 2.014 44.539*** 21.737** 4.468* 1.324
(0.769) (0.512) (0.000) (0.015) (0.082) (0.816)
CASHQ 5.653 6.795** 0.222 52.825 0.338 8.417
(0.649) (0.011) (0.933) (0.267) (0.952) (0.117)
MBQ 0.023 0.147* 0.442 0.118 1.003*** 0.812
(0.752) (0.075) (0.190) (0.716) (0.004) (0.431)
Constant 0.518 5.212 82.954*** 13.355 5.740*** 3.635
(0.923) (0.190) (0.000) (0.107) (0.004) (0.426)
Observations 152 152 152 159 159 159
Log likelihood
This table presents the results of the relation between audit quality measures and audit partner rotation for observations partitioned on firm complexity.
We retain only those observations in the top quartile of the number of geographic segments or firm size. See Appendix B for variable definitions. ***, **, and *
indicate, respectively, statistical significance at the 0.01, 0.05, and 0.10 levels (two-tails). Reported p-value are based on robust standard errors that are
contribute to this debate by providing empirical evidence using a sample of U.S. firms that disclosed information about audit
partner change. We examine the net effect of equity investors’ perceptions of audit partner rotation on audit quality, taking
into account both the costs and benefits associated with the partner rotation. Our results consistently indicate that investors
perceive the rotation of audit partner enhancing audit quality. We also find that short sellers, a group of sophisticated market
investors, regard earnings in the post-rotation to be of higher quality than earnings prior to audit partner rotation. The reduc-
tion in cost of equity capital following the audit partner rotation ranges from 80 bps to 150 bps. These findings are consistent
with the notion that investors perceive lower information risk as a result of audit partner rotation. Finally, we document sig-
nificant improvements in earnings persistence and predictive value of earnings for future cash flows following partner rota-
tion for small firms and firms followed by fewer analysts.
There is also some evidence that audit partner rotation has an adverse effect on audit quality for more complex
firms.
Our findings have important implications for regulators, auditors, managers, and others. First, to regulators in the U.S.
and in other regimes that are considering or eliminating mandatory rotation of audit partner, our findings point to a sig-
nificant benefit of audit partner rotation in the form of actual as well as perceived improvement in audit quality. Further,
the findings that improvements in audit quality following partner rotation for small firms and firms followed by fewer
analysts are potentially informative in understanding contexts where audit partner rotation is particularly beneficial. Sim-
ilarly, the adverse impact of the audit partner change on more complex firms is potentially relevant to regulators and
others.
Second, to managers and members of the board of directors of firms that comply with Section 203 of SOX but do not dis-
close information about audit partner rotation, our findings point to potential foregone benefits of disclosure (lower cost of
equity capital and higher earnings informativeness). Third, to audit firms that are concerned about the costs associated with
partner rotation, our findings suggest that there are potential benefits, especially from investors’ standpoint. Our findings
might be relevant to audit firms in formulating strategies to enhance audit quality through investment in developing exper-
tise of partners and staff.
Finally, we acknowledge that one limitation of our study is that our sample is small and firms that disclose informa-
tion about audit partner rotation tend to be large.28 Thus, our results should be interpreted as preliminary evidence of
investors’ perceptions of audit partner rotation. Future research could examine a larger sample of U.S. firms, especially
smaller firms.
Appendix A. Examples of disclosure on audit partner rotation
BROADRIDGE FINANCIAL SOLUTIONS, INC. (2014 Proxy statement)
The Audit Committee of the Board of Directors is directly responsible for the appointment, compensation, retention and
oversight of the work of the Company’s independent registered public accountants. The Audit Committee has appointed
Deloitte & Touche LLP as the independent registered public accountants for the Company and its subsidiaries for the fiscal
year ending June 30, 2015. In taking this action, the Audit Committee considered carefully the performance of Deloitte &
Touche LLP in that capacity since its retention when we became an independent public company in 2007, its independence
with respect to the services to be performed and its general reputation for adherence to professional auditing standards. The
Audit Committee also confirms that the lead audit partner or the lead audit partner responsible for reviewing the audit for
the Company’s independent registered public accountants has not performed audit services for the Company for more than
five consecutive fiscal years. A new lead partner was designated in 2014.
REGIONS FINANCIAL CORPORATION (2013 Proxy statement)
Ernst & Young LLP (or its predecessors) has served as Regions’ independent auditors since 1971.
A new lead audit partner is designated at least every five years to provide a fresh perspective. Consistent with this prac-
tice, a new lead audit partner was designated for 2013.
In determining whether to reappoint the independent auditor, the Audit Committee considers the independent auditor’s
qualifications, its independence and the length of time the firm has been engaged, in addition to considering the quality of
the work performed by the independent auditor and an assessment of the past performance of both the lead audit partner
and Ernst & Young LLP.
TITAN INTERNATIONAL, INC (2003 Proxy statement)
The Committee has met quarterly with management, internal auditors and the independent accountants, individually and
together, to review and approve the financial press releases, Form 10-Q and Form 10-K reports prior to their filing and
release of financial results for 2003. The Committee met in executive sessions a total of six times during 2003 and presents
a report to the Board at each Board meeting.
The Committee has selected PricewaterhouseCoopers LLP (‘‘PWC”) to serve as independent accountants for the Company
for 2004 with stockholder approval. The fees submitted by PWC for 2004 were approved by the Committee. Additionally, the
Committee has discussed the issue of independence with PWC and is satisfied that they have met the independence require-
ment. A standard five-year rotation of PWC partners for Titan’s account occurred in 2004, and the Committee inter-
viewed and approved the new partner.
28
Though our sample consists of larger firms, it is interesting to note that tests of audit quality (Table 8) indicate that improvements in audit quality is found
only for smaller firms and firms followed by fewer analysts. The mean and median values of total assets for the sub-sample of small firms are, $2.067 billion and
$1.816 billion. The mean and median values of total assets for the sub-sample of firms followed by fewer analysts are, $7.332 billion and $2.034 billion.
Appendix B. Variables definitions
ROTATE An indicator variable that equals 1 for the audit partner rotation year and the year after and equals 0 for
the two years before audit partner rotation
CAR (1, +1) 3-day Cumulative market-adjusted stock return around the earnings announcement date
CAR (2, +2) 5-day Cumulative market-adjusted stock return around the earnings announcement date
UE Abnormal earnings at quarter t scaled by stock price of quarter t 1. Abnormal earnings are the
difference between actual earnings per share and the most recent forecasted earnings per share
EPS Earnings per share at quarter i of year t
EPSPOST Earnings per share at quarter i of year t + 1
OCFPOST Operating cash flow per share at quarter i of year t + 1
SI The number of stock-split-adjusted shares shorted, scaled by the number of outstanding shares in the
month when quarterly earnings were announced
ABSI Abnormal short interest after controlling for firm size, book-to-market and return momentum in the
month when quarterly earnings were announced
COEPEG Proxy for cost of equity capital based on Easton’s (2004) PEG ratio at quarter i
COEOJ Proxy for cost of equity capital based on Ohlson and Juettner-Nauroth (2005) at quarter i
COEGLS Proxy for cost of equity capital based on Gebhardt et al. (2001) at quarter i
COEAVE The first principle component factor of the above three cost of equity capital proxies, at quarter i
BEATZERO An indicator variable that equals 1 if the quarterly earnings scaled by total assets is greater than or equal
to zero but less than 0.005, 0 otherwise
BEATZEROCH An indicator variable that equals 1 if the change in quarterly earnings scaled by total assets is greater
than or equal to zero but less than 0.005, 0 otherwise
BEATANALST An indicator variable that equals 1 if the quarterly earnings forecasted error is greater than or equal to
zero but less than 0.05, 0 otherwise
BETA Beta factor plus 1, log transformed at quarter i. Beta factor is based on a single factor market model using
monthly return for firms with at least 30 observations in the previous 60 months
BETASD Standard deviation of beta values over the previous year plus 1, log transformed
CASHSD Standard deviation of operating cash flow over the previous five years plus 1, log transformed
GROWTH Change in operating income at quarter i divided by total assets in the previous quarter
RET The cumulative raw stock return over the previous six months, in the month when quarterly earnings
were announced
TURN Average monthly share turnover over the previous six months, in the month when quarterly earnings
were announced. Share turnover is calculated as the number of monthly shares traded scaled by the
number of shares outstanding
INSTQ The percentage of shares owned by institutional investors at quarter i
SIZEQ Log of total assets at quarter i
LEVQ Total liability divided by total assets at quarter i
BMQ Book value of equity scaled by market value of equity at quarter i
CASHQ Operating cash flow scaled by total assets at quarter i
MBQ Market value of equity scaled by book value of equity at quarter i
ISSUE An indicator variable that equals 1 if the firm issued new equity in year t, 0 otherwise
INST Number of shares held by institutional investors scaled by total shares outstanding in year t
DISCLOSE An indicator variable that equals 1 for firms that disclosed information about rotation of audit partner in
year t, 0 otherwise
SIZEY Log of total assets at year t
LEVY Total liability divided by total assets at year t
BMY Book value of equity scaled by market value of equity at year t
ROAY Net income scaled by total assets at year t
GEOSEG The number of geographic segment at year t
ANALSTF The number of analyst following at year t
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Do Investors Perceive A Change in Audit Quality Following The Rotation of The Engagement Partner. 2019

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J. Account.

Public Policy 38 (2019) 146–168

Contents lists available at ScienceDirect

J. Account. Public Policy

Full length article

Do investors perceive a change in audit quality following the

2. Prior research and hypothesis

3.1. Empirical models

3.1.1. Earnings response coefficient

3.1.2. Short selling

SI=ABSI ¼ b0 þ b1 UE þ b2 UE ROTATE þ b3 ROTATE þ b4 SIZEQ þ b5 LEVQ þ b6 BMQ þ b7 RET þ b8 TURN þ b9 INSTQ

3.1.3. Cost of equity capital

XT1 FROEtþi r FROEtþT r

4.1. Univariate results

5.1. Earnings response coefficient

5.2. Short selling

VARIABLE N Mean Median SD P25 P75

5.3. Cost of equity capital

5.4. Robustness tests

5.4.1. Propensity score matching

CAR (1,+1) CAR (2,+2) UE ROTATE SIZEQ

SI ABSI UE ROTATE SIZEQ LEVQ BMQ MOM TURN INSTQ

(1) (2) (3) (4)

SI=ABSI ¼ b0 þ b1 UE þ b2 ROTATE þ b3 TREAT þ b4 UE TREAT þ b5 UE ROTATE þ b6 ROTATE TREAT þ b7 UE

COE ¼ b0 þ b1 ROTATE þ b2 TREAT þ b3 ROTATE TREAT þ b4 SIZEQ þ b5 LEVQ þ b6 GROWTH þ b7 BETA

5.4.2. Placebo test

(1) (2) (3) (4)

(1) (2) (3) (4)

(continued on next page)

Constant 0.018 0.043

BETA 0.034*** 0.034*** 0.031*** 2.001***

5.5. Additional analyses

EPSPOST ¼ b0 þ b1 EPS þ b2 EPS ROTATE þ b3 ROTATE þ RIND þ RYEAR þ e ð11Þ

OCFPOST ¼ b0 þ b1 EPS þ b2 EPS ROTATE þ b3 ROTATE þ RIND þ RYEAR þ e ð12Þ

BEAT ¼ b0 þ b1 ROTATE þ b2 SIZEQ þ b3 LEVQ þ b4 CASHQ þ b5 MBQ þ RIND þ RYEAR þ e ð13Þ

5.5.1. Audit partner rotation and earnings persistence

5.5.2. Audit partner rotation and earnings predictability

5.5.3. Audit partner rotation and meeting or beating earnings benchmarks

Variable N Mean Median SD P25 P75

(1) (2) (3)

Large firms Small firms

CASHQ 13.201 7.289*** 1.344 10.295 2.537* 2.837

5.5.4. Effects of audit partner rotation for more complex firms

Appendix A. Examples of disclosure on audit partner rotation

BROADRIDGE FINANCIAL SOLUTIONS, INC. (2014 Proxy statement)

REGIONS FINANCIAL CORPORATION (2013 Proxy statement)

TITAN INTERNATIONAL, INC (2003 Proxy statement)

Appendix B. Variables definitions

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BETA 0.034* 0.034* 0.031* 2.001*