Asian Journal of Business and Accounting, 5(1), 2012, 55-74

ISSN 1985-4064

Audit Tenure, Auditor Rotation, and Audit Quality:

The Case of Indonesia
Sylvia Veronica Siregar*, Fitriany Amarullah, Arie Wibowo and
Viska Anggraita
Abstract
The Indonesian regulators have made it compulsory to
rotate the appointments of public accountants every 3
years and the appointment of public accounting firms
every 5 years, since the end of 2002. The purpose of this
study is to investigate the effects of auditor rotation and
audit tenure of the public accountant and the public
accounting firm, on audit quality (before and after the
implementation of the mandatory auditor regulation). The
results do not support that mandatory auditor rotation
increases audit quality or that a shorter audit tenure (both
partner and firm level) increases audit quality. Regulators
may need to consider revising the regulation (i.e. related to
maximum years allowed for auditor to audit their client)
and/or introduce other regulations to increase audit
quality.
Keywords: Audit rotation, Audit tenure, Audit quality,
Discretionary accrual
JEL Classification: M42

1.

Introduction

Many major corporate collapses, such as Enron and WorldCom in the

United States, have been attributed to poor audit quality associated with
a perceived lack of auditor independence. These alleged audit failures
were deemed to have occurred because auditors failed to either detect or
report material errors/misstatements in the financial statements.
Mandatory auditor rotation has frequently been suggested as a means of
*

Corresponding author. Sylvia Veronica Siregar is a Lecturer at the Faculty of Economics,

Universitas Indonesia, Depok, Indonesia, e-mail: sylvia.veronica@ui.ac.id. Fitriany
Amarullah is a Lecturer at the Faculty of Economics, Universitas Indonesia, Depok,
Indonesia, e-mail: fitri_any@yahoo.com. Arie Wibowo is postgraduate student at Graduate
Program in Accounting, Faculty of Economics, Universitas Indonesia, Depok, Indonesia, email: ariewibowo@gmail.com. Viska Anggraita is a Lecturer at the Faculty of Economics,
Universitas Indonesia, Depok, Indonesia, e-mail: viskaviska257@yahoo.co.id
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Sylvia Veronica Siregar, Fitriany Amarullah, Arie Wibowo and Viska Anggraita

strengthening independence and reducing the incidence of audit failure

(Catanach & Walker, 1999).
There are arguments for and against mandatory auditor rotation.
Proponents of auditor rotation argue primarily that rotation can remedy
the potential reduction in auditor independence and the related declines
in the quality of financial reporting resulting from lengthy auditor-client
relationships (Gavious, 2007). In addition to pressures to retain the client,
an extended relationship may cause the auditor to become complacent.
This could lead to substandard audits and/or auditors tending to agree
with client preferences, which result in poor earnings quality (Myers,
Myers, & Omer, 2003). Proponents also argue that rotation would bring a
fresh look at firms financial statements which might increase the
likelihood that the auditor will be able to detect misstatements and/or
challenge questionable accounting practices. It is considered as an
effective way of ensuring auditor objectivity and independence, as well
as preventing opinion shopping (Crabtree, Brandon, & Maher, 2006;
Lu & Sivaramakrishnan, 2009). Lastly, it is suggested that rotation could
lead to audit innovations that allow auditors to audit new clients more
efficiently (Crabtree et al., 2006).
Opponents of auditor rotation (generally led by the accounting
profession) argue that mandatory auditor rotation increases audit startup costs and increases audit failure risk. They argue that new auditors
must rely more heavily on management estimates and representation in
the initial years of an audit engagement (Myers et al., 2003). As auditor
tenure increases, the auditor learns more about the client and its business
processes, allowing the auditor to reduce reliance on management
estimation and representation, resulting in a more effective audit
(Crabtree, 2004). In other words, they believe that extended auditorclient relationships actually increase audit quality; the new auditor will
not have the benefit of client-specific knowledge of a previous auditor
(GAO, 2003). According to Lu & Sivaramakrishnan (2009), this poor
knowledge of the new auditor hampers the effectiveness of the audit
process and can result in a deadweight loss to society. Management also
tends to be opposed to mandatory auditor rotation, because they face the
potentially disruptive, time-consuming, and expensive process of
selecting new auditors, and familiarising them with the organisations
operations, procedures, systems, and industry (AICPA, 1992).
Auditor rotation can take place at the firm or partner level.
Mandatory audit firm rotation is still being debated in most places, but
audit partner rotation has been adopted in certain countries. The
professional requirements in the U.S. state that the partner in charge of
an audit engagement should be replaced at least once every seven years.
The Sarbanes-Oxley Act of 2002 further requires audit partner rotation at
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Audit Tenure, Auditor Rotation, and Audit Quality: The Case of Indonesia

least once every five years. In the UK, audit partner rotation has been a
requirement for many years, and in January 2003, the maximum period
for rotation of the lead partner was reduced from seven to five years.
Requirements for audit partner rotation also have been adopted in the
Netherlands and Germany. In Japan, beginning from April 2004, audit
partners and reviewing partners were prohibited from being engaged in
auditing the same listed company over a period of seven consecutive
years (Chen, Lin, & Lin, 2008).
Regardless of the debate surrounding audit firm rotation, this
audit firm rotation rule was introduced in a few countries (Comunale &
Sexton, 2005; Cameran, Di Vincenzo, & Merlotti, 2005). Italy has adopted
mandatory audit firm rotation, while Brazil has adopted mandatory
audit firm rotation for banks and listed companies. Several Asian
countries have adopted mandatory adoption too. South Korea requires
mandatory auditor firm rotation for companies listed in KSE (Korean
Stock Exchange) or registered with KOSDAQ (Korea Securities Dealers
Automated Quotations) every six years (starting in 2006). Exceptions are:
1) foreign-investment companies, which are subsidiaries of foreign
parent companies as defined by the laws of that country and which
intend to appoint the same auditors as the parent and 2) companies
listed on foreign exchange (NYSE, NASDAQ, and London Stock
Exchange only). Singapore has adopted a similar requirement for banks
from March 2002. The Monetary Authority of Singapore requires that
banks incorporated in Singapore should not appoint the same public
accounting firm for more than 5 consecutive financial years. This
requirement does not apply to foreign banks operating in the country.
India also requires mandatory auditor rotation every 4 years for banks,
privatised insurance companies, and government companies. Austria,
Spain, Canada, Slovakia, and Turkey adopted mandatory audit firm
rotation but have since eliminated their requirements. Ireland considered
and rejected a policy of mandatory audit firm rotation. Table 1 shows
countries in Asia that have adopted mandatory audit firm and partner
rotation.
In the case of Indonesia, collapses of many companies and banks
during the Asian crisis in 1997-1998 have also raised concerns about the
poor audit quality associated with a perceived lack of auditor
independence. Only a few months after the enactment of the SarbanesOxley Act in July 2002 in the U.S., in September 2002, the Indonesian
Finance Minister signed a Decree on Public Accountant Services (Finance
Minister Decree No. 423/KMK.06/2002). This decree mandates auditor
partner rotation for three years and audit firm rotation for five years.
This decree was revised with the PMK No. 17/PMK.01/2008 where
restrictions on the provision of services of audit firms was changed to a
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Sylvia Veronica Siregar, Fitriany Amarullah, Arie Wibowo and Viska Anggraita

maximum of 6 (six) consecutive fiscal years. In 2011 the government

issued a Public Accountant Law that gives authority to the Ministry of
Finance to determine whether or not to apply the rotation rule. Until
now the Ministry of Finance has not issued any new rules regarding the
rotation of the public accountant (auditor). Currently the PMK No.
17/PMK.01/2008 still applies; it requires an audit firm rotation every 6
years while audit partner rotation remains at 3 years.
Table 1: Countries in Asia that have Adopted Mandatory Audit Firm and
Audit Partner Rotations
Country

Mandatory audit firm rotation

Mandatory audit partner rotation

Bangladesh

Yes - every 3 years for listed companies

Japan

Yes - every 3 years for listed

companies
Yes - every 5 years for
government state-owned
companies
No
Yes - every 4 years for banks,
privatised insurance companies
and Government companies
Yes - every 6 years for all
companies
No

Malaysia

No

China

Hongkong
India

Indonesia

Pakistan

Yes - every 5 years for listed

companies
Philliphines No

Yes - every 5 years for all listed companies

Yes - every 5 years for all listed companies

Yes - every 4 years for banks, privatised
insurance companies and Government
companies
Yes - every 3 years for all companies
Yes - every certain period within 7 years
for listed companies
Yes - every 5 years for listed companies
and public interest entities
Yes - every 5 years for listed companies

Yes - every 5 years for listed companies

and bank
Singapore
Yes - every 5 years for local bank Yes - every 5 years for listed companies
Srilanka
No
Yes - every 5 years for listed companies
South Korea Yes - every 6 years for KSE listed Yes - every 6 years for KSE listed
companies or KOSDAQ
companies or KOSDAQ registered except
registered except foreignforeign-invested companies and/or listed
invested companies and/or listed on foreign exchange
on foreign exchange
Taiwan
No
Yes - every 5 years for listed companies
Thailand
Yes - every 5 years for listed
Yes - every 5 years for listed companies
companies

This issue has raised many concerns, especially from the

accounting profession. They make the same arguments such as those
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Audit Tenure, Auditor Rotation, and Audit Quality: The Case of Indonesia

discussed above, but there is no empirical evidence in the Indonesian

context to support their arguments. Most studies on audit tenure and
auditor rotation are conducted in other countries (e.g. Ghosh & Moon
(2005), Nagy (2005), Myers et al. (2003), Geiger & Raghunandan (2002),
Johnson, Khurana & Reynolds (2002) in US; Cameran, Livatino,
Pecchiari, & Vigano (2002) in Italy; Chi & Huang (2005) in Taiwan;
Chung (2004) in Korea). These previous studies provide empirical
evidence regarding the efficacy of restricting audit tenure (auditor
rotation) in several countries. However, it is uncertain whether such
findings are applicable in Indonesia as Indonesia still has poor law
enforcement. CLSA Survey conducted in 2010 showed that of the 11
countries surveyed, Indonesia is one of the countries that showed an
increase in the application of corporate governance (CLSA, 2010).
However, in terms of the total score of corporate governance, Indonesia
is one of the countries that has low law enforcement. Lack of strong law
enforcement and also low penalties for violations committed by public
accountants (World Bank, 2010) mean that auditors in Indonesia have no
explicit liability to the company, shareholders, or other investors, and no
accounting firm has been sued for substandard work by companies,
shareholders, or third parties. These are factors which can lead to failure
to achieve objectives of the ruling, so it is important to investigate the
effect of audit tenure and auditor rotation in Indonesia.
Our study has four contributions. First, we examine the period
before mandatory auditor regulation and the period after. Second, we
examine the non linear relationship between audit tenure and audit
quality, which has rarely been examined in prior studies. Third, we
examine the effects of both audit tenure and auditor rotation. Fourth, we
provide evidence on audit tenure and auditor rotation, both at partner
level and firm level. Most prior studies only investigate either audit firm
rotation or audit partner rotation.
This study provides useful insights for the regulation of public
accountants in Indonesia in order to ensure the independence and
competence of public accountants. This study examines the effectiveness
of the auditor rotation rule, i.e. Finance Minister Decree No.
423/KMK.06/2002. We believe that the application of this rule raises the
cost for public accountants, corporations, and governments. A study by
GAO (2003) finds that almost all of the largest public accounting firms
and Fortune 1000 publicly traded companies believe that the costs of
mandatory audit firm rotation are likely to exceed the benefits. This
study finds that the rotation rule does not improve audit quality and that
the government (in this case the Ministry of Finance) needs to reconsider
whether its decision on mandatory auditor rotation is achieving its
purpose(s).
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2.

Previous Studies and Hypotheses Development

Audit quality is another important aspect to be considered in evaluating

the usefulness of auditor rotation. Audit quality, according to DeAngelo
(1981, p.186), is market-assessed joint probability that a given auditor
will both (a) discover a breach in the clients accounting system, and (b)
report the breach. Jackson, Moldrich, & Roebuck (2008) view the quality
of audits from actual and perceived quality. Actual quality shows levels
of risk of material errors in financial statements that can be reduced by
the auditor. Perceived quality indicates the level of confidence of users in
financial statements, and the auditor's effectiveness in reducing material
misstatement in financial statements prepared by management. In this
study, we use earnings quality as a measure of audit quality. Basically,
an audit conducted by an external auditor aims to determine whether the
numbers in the financial statements are fairly presented and reflect the
true state of a firms operating results and financial condition. If the
audit quality is "poor", then the resulting accounting earning numbers
will be less accurate in reflecting the operating results and the financial
condition (Chen et al., 2008). Therefore, earnings quality is used as a
proxy of audit quality.
Earnings consists of two elements: accruals and cash flows. We
focus on the accrual component of earnings because the accrual
component of earnings is subject to greater uncertainty than is the cash
flow component. Accruals are the product of judgments, estimates, and
allocations (of cash flow events in other periods), whereas the cash flow
component of income is realised (Francis, LaFond, Olsson, & Schipper,
2005). Furthermore, accruals can be divided into discretionary and nondiscretionary accrual components. Non-discretionary accruals are
accounting adjustments to the firm's cash flows mandated by accounting
standard-setting bodies, while discretionary accruals are adjustments to
cash flows selected by the manager in order to affect reported net income
(Healy, 1985). Higher discretionary accruals indicates lower earnings
quality, hence in this research, audit quality is measured by the level of
discretionary accruals. The benefit of using discretionary accruals as a
measure of audit quality is that it reflects the auditors enforcement of
accounting standards (Lawrence, Minutti-Mega, & Zhang, 2011). Some
studies also use discretionary accruals (Johnson et al., 2002; Myers et al.,
2003; Lawrence, Minutti-Mega, & Zhang, 2011) as a proxy for audit
quality.
Geiger and Raghunandan (2002) find that there were
significantly more audit reporting failures in the earlier years of the
auditor-client relationship than when auditors had served these clients
for longer tenures. Reporting failure is defined as a case where the
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bankrupt company did not receive a going-concern modified audit

report from their auditor prior to bankruptcy. Their results do not
support the arguments of those who propose mandatory auditor rotation
and suggest that, contrary to the concerns expressed by the SEC, there is
an inverse relationship between auditor tenure and audit reporting
failures. Carcello and Nagy (2004) use cited fraudulent financial
reporting as a proxy for audit quality. They find that fraudulent financial
reporting is more likely to occur in the first three years of audit firm
tenure, but they fail to find evidence that fraudulent financial reporting
is more likely, given long audit firm tenure.
Johnson et al. (2002) investigate the relationship between audit
firm tenure and absolute discretionary accruals. They classify audit firm
tenure into three categories: short (two to three years), medium (four to
eight years), and long (nine or more years). They use the group of
medium tenure as a benchmark and find that short tenure is associated
with larger absolute discretionary accruals but long tenure is not, which
suggest that long audit firm tenures are not associated with a decline in
earnings quality.
Myers et al. (2003) investigate the relation between audit firm
tenure and two measures of accruals: discretionary accruals and current
accruals. They find that the magnitude of both measures of accruals
declines with longer audit firm tenure. They also find that longer audit
firm tenure is associated with both less extreme income-increasing, and
less extreme income-decreasing accruals, which suggests that earnings
management becomes more limited as audit firm tenure gets longer.
Overall, they find no evidence that a longer audit firm tenure is
associated with lower earnings quality.
Chi and Huang (2005) find that discretionary accruals initially
are negatively associated with audit partner tenure and audit firm
tenure, but the associations become positive after the tenure exceeds five
years. They interpret this result as suggesting lower earnings quality
when the auditor is excessively familiar with the client. However, the
empirical tests in Chi and Huang (2005) do not include absolute
discretionary accruals, and do not separate positive and negative
discretionary accruals. Chen et al. (2008) report a negative relationship
between audit partner tenure and the absolute value of unexpected
accruals, from a sample of Taiwanese firms from 1990-2001. Although
they conclude that concerns about the effect of audit partner tenure
could be misplaced, they do not separately examine instances of positive
and negative unexpected accruals (i.e., they treat over and under
accruing symmetrically). They also exclude the first year of the incoming
partners engagement responsibility, despite the fact that the most
marked effect of a rotation might be expected to occur at that time.
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Additional evidence of Taiwanese audit partner rotation is

provided by Chi, Huang, Liao, and Xie (2009). They examine partner
rotations occurring under a regime of mandatory rotation introduced
from 2004. While they find some results consistent with higher quality
auditing for those firms subject to mandatory rotation, this does not hold
true when these same firms are used as a control (i.e., when results for
2004 are compared to 2003). However, they do identify a consistent
pattern in earnings-response coefficients, which they interpret as
evidence of improved auditor independence in appearance, if not in fact.
Further evidence of the possible effect of audit firm tenure is
provided by Kim, Min, & Yi (2004). They examine the relatively unique
setting that prevails in Korea, whereby the securities regulator can
appoint a designated auditor to replace the incumbent, so that the
auditor is not selected by the client firm, but rather by the regulator.
They find that unexpected accruals are lower (i.e., less positive) in years
following mandatory auditor rotation. But the authors concede that the
mandatory switch to a designated auditor typically follows and/or
coincides with significant financial distress, as well as broader corporate
governance issues. However, it is also possible that the effects they
observe as being associated with mandatory audit firm rotation, reflect
the likelihood that such effects are most likely to be observed where the
switch of audit firms is not voluntary.
Myers et al. (2003), Chi and Huang (2005), and Chen et al. (2008)
indicate that longer audit tenure is not associated with a decline in audit
quality. However, Vanstraelen (2000) in the Belgium context, Davis, Soo,
and Trompeter (2003) in the US context, and Chung (2004) in the Korea
context, find inconsistent results. Vanstraelen (2000) finds that long-term
auditor-client relationships significantly increases the likelihood of an
unqualified opinion. Davis et al. (2003) provide evidence that audit
tenure is associated with lower financial-reporting quality, and they
suggest that management gains greater reporting flexibility and is able to
meet earnings forecasts more easily, as auditor tenure increases. Chung
(2004) finds that discretionary accruals by firms that fulfill the rotation
requirement decrease after the passage to a mandatory rotation regime.
This suggests that audit quality seems to improve when the length of
auditor-client relationship is limited.
We find several studies related to audit tenure in the Indonesian
setting. Mayangsari and Wahyuni (2005) investigate the effects of audit
firm tenure on earnings quality and Mayangsari and Sudibyo (2005)
investigate the effects of audit tenure on probability of auditor litigation.
Both studies find that there is significant and linear relation between
audit tenure and earnings quality (probability of auditor litigation). But
these studies only use audit firm tenure and do not consider audit
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partner tenure. Fanny & Siregar (2007) examine both audit firm and
audit partner tenure and rotation. They find that audit firm rotation
increases discretionary accruals but audit partner rotation does not have
significant effects; whereas both audit firm tenure and audit partner
tenure are associated with lower discretionary accruals. This study adds
to existing literature in Indonesia by examining non-linear relationships
between audit partner and audit firm tenure and audit quality.
Both proponents and opponents of mandatory rotation have
their own arguments with evidence to support them. Proponents of
mandatory rotation (Catanach and Walker, 1999; Johnson et al., 2002;
Crabtree, 2004; Chen et al., 2008) argue that it will prevent long-term
auditor-client relationships that could impair independence and
objectivity. Over time, auditors incentives shift toward maintaining and
profiting from the client and auditors become less concerned with
litigation relating to client. Auditors become less objective and apply less
effort toward the detection of material misstatements. They propose that
mandatory rotation would bring a fresh look at firms financial
statements which might increase the likelihood that the auditor will
uncover misstatements and/or challenge questionable accounting
practices. Rotation could lead to audit innovations that allow auditors to
audit new clients more efficiently. If the tenure period were limited,
auditors also would have greater incentives to resist management
pressures (AICPA, 1992, 12). Finally, supporters of rotation suggest that
it would foster a more competitive market.
Opponents of auditor rotation argue that mandatory auditor
rotation increases audit start-up costs and increases the risk of audit
failure because new auditors must rely more heavily on management
estimates and representation in the initial years of an audit engagement
(Myers et al., 2003). As auditor tenure increases, the auditor learns more
about the client and its business processes, allowing the auditor to
reduce reliance on management estimation and representation, resulting
in a more effective audit (Crabtree, 2004). In addition, new auditors will
not have the benefit of client-specific knowledge of a previous auditor
(GAO, 2003), and this weakens the effectiveness of the audit process (Lu
& Sivaramakrishnan, 2009). Another argument against mandatory
rotation (Catanach and Walker, 1999) is that the predecessing auditors
will not be able to transfer their knowledge of the client, its accounting
system, and market to successors, and this value is destroyed by
rotation. Managements tend to be opposed to mandatory auditor
rotation because they face potentially disruptive, time-consuming, and
expensive processes of selecting new auditors, and familiarising them
with the organisations operations, procedures, systems, and industry
(AICPA, 1992). Another concern is that new auditors may not have the
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industry expertise or may not possess the same level of firm specific
knowledge required to audit a new client effectively (Dunham, 2002).
Based on two arguments above, the relationship between audit
tenure and audit quality can be depicted as follows:
Figure 1: Relationship between Audit Tenure and Audit Quality

From the preceding explanation, we expect there is a non-linear

(quadratic and concave) relationship between audit tenure and audit
quality. Because we measure audit quality by discretionary accruals,
where higher discretionary accruals indicate lower audit quality, we
posit that the relationship between auditor tenure and discretionary
accruals is quadratic and convex. Hence, we formulate the following
hypotheses:
H1a: The relationship between audit partner tenure and
discretionary accruals is non-linear (quadratic and convex)
H1b: The relationship between audit firm tenure and
discretionary accruals is non-linear (quadratic and convex)
As mentioned above, both proponents and opponents of mandatory
auditor rotation have their own arguments with evidence to support
them. However, which arguments are valid, is an empirical question.
Hence, we make no prediction for the following hypotheses:
H2a:
H2b:

3.

Audit partner rotation is associated with discretionary

accruals
Audit firm rotation is associated with discretionary
accruals

Research Method

We used the following research model to test above hypotheses:

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Audit Tenure, Auditor Rotation, and Audit Quality: The Case of Indonesia

ABSDACit

= 0 + 1PTENUREit + a2 PTENURE2it + 3 FTENUREit +

4FTENURE2it + 5PROTATIONit + 6FROTATIONit +
7SPECit + 8BIG4t + 9LEVit + 10GROWTHit + 11SIZEit
+ it

Whereas:
DAC

PTENURE

FTENURE

PROTATION

FROTATION

SPEC

BIG4

LEV
GROWTH
SIZE

=
=
=

absolute discretionary accruals

We used the cross sectional Kasznik (1999) model
to calculate discretionary accruals:
TACCit/TAi,t-1 = 1(1/TAi,t-1) + 2(REVit
RECit)/TAi,t-1 + 3PPEi,t/TAi,t-1 + 3CFOi,t/TAi,t-1 +
it
TACCit = total accrual year t, TAit-1 = total asset at
the beginning of year t, REVit = change in
revenue between year t and t-1, RECit = change
in receivables between year t and t-1, PPEit
=
gross property, plant, and equipment in year t,
CFOit = change in cash flows from operation
between year t and t-1
the length of time the Audit Partner has been the
auditor of a company in a given year (number of
years).
the length of time the Public Accounting Firm has
been the auditor of a company in a given year
(number of years).
dummy variable, 1 if there is audit partner
rotation and 0 otherwise
dummy variable, 1 if there is audit firm rotation
and 0 otherwise
dummy variable, 1 if the company is audited by
specialised auditor (have > 10% market share in an
industry, based on its clients total asset) and 0
otherwise.
dummy variable, 1 if the company is audited by
Big4 and 0 otherwise
debt-to-total asset
price-to-book value
natural logarithm of ending book value of total
assets

We use SPEC, BIG4, LEV, GROWTH, and SIZE as control

variables. SPEC, BIG4, GROWTH, and SIZE are expected to have
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Sylvia Veronica Siregar, Fitriany Amarullah, Arie Wibowo and Viska Anggraita

negative relationships with discretionary accruals, whereas LEV is

expected to have positive relationships.
We used two observation periods in this study: year 1999 2001
to represent years before mandatory auditor rotation regulation (KMK
No. 423/KMK.06/2002) and year 2004-2008 for years after the mandatory
auditor rotation regulation. We excluded years 2002 and 2003, because
those were the first years of implementating the regulation.

4.

Results and Discussion

Table 2 presents descriptive statistics for both periods i.e. before and
after mandatory auditor rotation regulation. The mean of DAC after
mandatory auditor rotation (0.0640) is smaller than periods before
(0.1151). Audit tenure, for both audit partners and audit firms, is shorter
for the periods after. PTENURE and FTENURE have high standard
deviations because of auditor switching for several firms, especially large
ones, and in certain industries they are not always easy. They may need
specialised auditors and more auditor resources in terms of audit staff
force, to audit their financial statements. Hence, this condition makes
PTENURE and FTENURE longer in some firms but shorter for other
firms, resulting in a high standard deviation. Auditor rotation also
increased due to the effect of the regulation. After the implementation of
the regulation, fewer firms were audited by the BIG4. This is a
consequence of the regulation, which reduced the market share of the
Big 4 accounting firms.
Regression results for periods before and after the mandatory
auditor regulation are presented in Table 3. From regression results in
Panel A and Panel B of Table 3, we can see that hypotheses 1a and 1b
regarding non linear relationships between auditor tenure (both for
audit partner and audit firm) are not supported. AUDIT PARTNER
TENURE has a negative significant relationship with discretionary
accruals for the period before mandatory auditor rotation regulation, but
it has a positive significant relationship for the period after. These
findings indicate that before auditor rotation became mandatory, longer
audit partner tenure was associated with higher audit quality (lower
discretionary accruals), whereas after auditor rotation became
mandatory, a longer audit partner tenure became associated with lower
audit quality. There is no significant relationship between AUDIT FIRM
TENURE and discretionary accruals for the period before auditor
mandatory regulation, but there is a positive relationship for the period
after. The positive result for audit firm tenure is consistent with audit
partner rotation result as well.

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The results for the period after mandatory auditor

rotation do not provide support for the current regulation to mandate
auditor rotation. Limitation of tenure still results in lower audit quality.
Meanwhile, in the period before auditor rotation is mandatory, a longer
auditor tenure is associated with higher audit quality. The possible
explanation for these results is that the r egulation mandates that after
3 years and 5 years, the audit partner and audit firm should be rotated
respectively. As a result, the auditor may not be familiar enough with the
client to have firm-specific knowledge to audit the client effectively. This
finding is consistent with Carcello and Nagy (2004), who find that
fraudulent financial reporting is more likely to occur in the first three
years of audit firm tenure. This evidence suggests that the regulator may
need to consider changing the mandatory length of auditor tenure.
Maybe a longer auditor tenure is needed to provide auditors enough
time to obtain knowledge regarding their clients. There is another
possible explanation for these findings. There is a positive effect of audit
partner tenure and audit firm tenure on discretionary accruals in the
period after mandatory auditor regulation. Whereas in the period before
mandatory regulation, the effect is negative for audit partner (not
significant for audit firm) and may indicate that mandatory limitation on
audit tenure may not be warranted. The negative effect of auditor tenure
on audit quality only emerged after the regulator enacted the tenure
limitation. The results from auditor rotation also support this
explanation.
Table 3 we can see that for years before mandatory auditor
rotation regulation, AUDIT PARTNER ROTATION had negative signs,
while AUDIT FIRM ROTATION had positive signs. These indicate that
firms which do audit partner rotation have lower discretionary accruals
(higher audit quality) than firms without audit partner rotation, but
firms which have audit firm rotation have higher discretionary accruals
(lower audit quality) than firms without audit firm rotation. In
contradiction, there are no significant results for both audit partner and
audit firm rotation in the years after the regulation. These results suggest
that audit partner rotation has positive effects on audit quality but only
in voluntary situations (not mandatory by regulation) and that after
auditor regulation is mandated there is no evidence that it has a positive
and significant effect on audit quality. If we compare these results with
those of audit partner tenure and audit firm tenure, the result is not
contradictory. It is possible that although audit firm partner (audit firm)
is changed every 3 years (5 years), old and new auditors do not affect the
level of discretionary accruals because both do not have sufficient
knowledge of their clients business and risk. The insignificant affect of
auditor rotation on audit quality suggests that the existing mandatory
Asian Journal of Business and Accounting, 5(1), 2012

67

Sylvia Veronica Siregar, Fitriany Amarullah, Arie Wibowo and Viska Anggraita

auditor rotation may not be an effective mechanism to increase audit

quality. The regulation about rotation in Indonesia has a loophole where
firms may seem to have changed their audit firms, but actually this is not
the case. The audit firms only change the local name of their audit firms
by changing 50% of its audit partners, but their foreign affiliates do not
change (e.g., quasi rotation). Afriansyah & Siregar (2007) and Fitriany
(2010) find evidence regarding this quasi rotation.
Table 2: Descriptive Statistics
Panel A: Year 1999 -2001 (Period Before Mandatory Auditor Regulation)
Variable
DAC
PTENURE
FTENURE
PROTATION
FROTATION
SPEC
BIG4
LEV
GROWTH
SIZE (in Rp 000.000)
N = 559

Minimum
0.0000
1
1
0
0
0
0
0.0300
-2.4600
20,070

Maximum
1.0379
12
12
1
1
1
1
4.6900
4.4000
58,275,211

Mean
0.1151
3.2021
5.1431
0.3560
0.1342
0.5921
0.7853
0.7788
0.9487
1,881,855

Std. Deviation
0.1338
2.7383
3.1024
0.4792
0.3411
0.4919
0.4110
0.5860
1.0986
4,569,463

Panel B: Year 2004 -2008 (Period After Mandatory Auditor Regulation)

Variable
DAC
PTENURE
FTENURE
PROTATION
FROTATION
SPEC
BIG4
LEV
GROWTH
SIZE (in Rp 000.000)
N = 1,132

68

Minimum
0.00001
1
1
0
0
0
0
-0.1798
-2.2000
4,976

Maximum
0.67657
5
9
1
1
1
1
5.1945
4.6200
102,887,052

Mean
0.0640
1.6837
2.2473
0.5035
0.3675
0.4231
0.4417
0.5929
1.1731
3,326,034

Asian Journal of Business and Accounting, 5(1), 2012

Std. Deviation
0.0654
0.7736
1.2744
0.5002
0.4823
0.4943
0.4968
0.4502
1.0821
9,574,922

Audit Tenure, Auditor Rotation, and Audit Quality: The Case of Indonesia

Table 3:Regression Results

Panel A: Year 1999 -2001 (Period Before Mandatory Auditor Regulation)
Variable
C
PTENURE
PTENURE2
FTENURE
FTENURE2
PROTATION
FROTATION
SPEC
BIG4
LEV
GROWTH
SIZE
Adj R2
F-stat
p-value

Expected Sign
+
+
+/+/+
+
0.1688
11.3006
0.0000

Coefficient
0.3950
-0.0287
0.0002
-0.0027
0.0005
-0.0350
0.0386
-0.0212
0.0187
0.0869
-0.0074
-0.0115

t-stat
3.9213
-1.7400
0.4955
-0.9106
0.6347
-1.9233
1.5294
-1.6225
1.0950
8.9787
-1.4488
-3.0265

p-value
0.0001
0.0412
0.3102
0.1814
0.2629
0.0275
0.0634
0.0526
0.1370
0.0000
0.0740
0.0013

***
**

**
*
*
***
*
***

***

Note: *, **, *** denotes significance at the 0.1, 0.05 and 0.01 levels, respectively

Panel B: Year 2004 -2008 (Period After Mandatory Auditor Regulation)

Variable
C
PTENURE
PTENURE2
FTENURE
FTENURE2
PROTATION
FROTATION
SPEC
BIG4
LEV
GROWTH
SIZE
Adj R2
F-stat
p-value

Expectation
+
+
+/+/+
+
0.0801
4.5619
0.0000

Coefficient
0.1869
0.0135
0.0008
0.0073
0.0061
-0.0006
0.0012
0.0017
-0.0088
0.0274
0.0036
-0.0060

t-stat
4.0248
2.3755
0.0625
1.5087
1.2676
-0.4509
0.1993
0.2477
-1.3725
5.0187
1.4217
-3.5587

p-value
0.0001
0.0090
0.4751
0.0661
0.1028
0.6523
0.8421
0.4023
0.0853
0.0000
0.0779
0.0002

***
***
*

*
***
*
***

***

Note: *, **, *** indicate significance at the 0.1, 0.05 and 0.01 levels, respectively

LEV and SIZE are the only control variables which have
consistent results as predicted. These findings are consistent with the
debt covenant hypothesis and the political cost hypothesis. SPEC only
has negative effects on discretionary accruals (positive effect on audit
Asian Journal of Business and Accounting, 5(1), 2012

69

Sylvia Veronica Siregar, Fitriany Amarullah, Arie Wibowo and Viska Anggraita

quality) in the period before the regulation. This may be due to the
existence of other new regulations besides mandatory auditor rotation
that enhance quality such as the adoption of IFRS convergence, so it will
mitigate SPECs effect on audit quality. Firms audited by the BIG4 had
lower discretionary accruals than firms audited by non Big 4 accounting
companies only in the years after the regulation. because in that period a
firm had to hire a new public accounting firm after 5 years, and the BIG
4 had better resources, human capital, and quality than the non Big 4 in
the first year assignment, despite the familiarity effect. GROWTH,
however, had inconsistent results between both periods. This maybe
because the proxy we chose (PBV) was not the best proxy for growth.
Market value may include such subjective elements as analyst views and
speculation and book value may depend on subjective estimation of
assets (Kogan & Papanikolaou, 2010).
Overall results show evidence more consistent with opponents
of the auditor rotation arguments. Although there is evidence that
longer audit tenure results in lower audit quality for the period after
mandataory auditor rotation, this relationship does not hold for the
period before mandatory auditor rotation; and the results also show that
auditor rotation after the regulation was enacted do not have positive
effects on audit quality. These findings suggest that extended auditorclient relationships seems to increase audit quality, which may stem
from the fact that as auditor tenure increases, the auditor learns more
about their client and the clients business processes, which results in a
more effective audit (Crabtree, 2004). Also, new auditors may not have
the industry expertise or may not possess the same level of firm specific
knowledge required to audit a new client effectively compared to old
auditors (Dunham, 2002).

5.

Conclusion

Our results show that longer audit tenure became associated with lower
audit quality for the period after mandataory auditor rotation, but
conversely for the period before it became mandatory, longer audit
tenure increased audit quality. The results also show that auditor
rotation before regulation (voluntary rotation) did increase audit quality,
whereas mandatory auditor rotation does not show having positive
effects on audit quality. Overall, we do not find strong evidence to
support the notion that the existing mandatory auditor rotation is
effective to increase audit quality. The conflicting results are probably
due to the low law enforcement in Indonesia. Besides, there is a loophole
in the rotation regulation that allows audit firms to do quasi rotation.
Further research about audit rotations can examine the effect of quasi
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Asian Journal of Business and Accounting, 5(1), 2012

Audit Tenure, Auditor Rotation, and Audit Quality: The Case of Indonesia

and rill rotation on audit quality. The evidence suggests that the
regulator may need to examine whether the negative effect of auditor
tenure on audit quality may become positive if the regulator changes the
maximum years allowed for an auditor to audit their clients and/or
develops other mechanisms to increase audit quality and also to
maintain auditor independency.
There are several limitations to this study. First, we only used
discretionary accruals as a proxy of audit quality. Further studies may
use another proxy for audit quality or use several proxies for audit
quality. Second, we have not examined the relationship between audit
tenure and auditor rotation on audit quality for each industry. Third, we
have not considered corporate governance variables as a variable that
may affect the relationship between audit tenure and auditor rotation
with audit quality.
The results of these findings can be a valuable input for
regulators to reconsider the rules of the rotation in Indonesia. The
decline in audit quality following the rules of rotation indicates the need
for other mechanisms created by the institutions of public accountants
Indonesia (IAPI) such as peer review and effective training to improve
the competence of auditors. The other implication is the desirability of
enriching Indonesias literature on the relationship between the auditor
rotation, audit tenure, and audit quality in the context of developing
countries, and supporting future possible research.

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