An Experimental Investigation of Retention and Rotation Requirements

Journal of Accounting Research
Vol. 39 No. 1 June 2001

Printed in U.S.A.
An Experimental Investigation
of Retention and
Rotation Requirements
N I C H O L A S D O P U C H ,∗ R O N A L D R . K I N G ,∗
A N D R A C H E L S C H W A R T Z∗
Received 11 August 1998; accepted 29 November 2000
ABSTRACT
We provide results from an experiment designed to assess whether manda-

tory rotation and/or retention of auditors increases auditors’ independence
by reducing their willingness to issue reports biased in favor of manage-
ment. Auditors’ reporting is compared across the following four regimes:
one that does not require either rotation or retention, a second that re-
quires retention only, a third that requires rotation only, and a fourth that
requires both rotation and retention. We find that the rotation require-
ments in the third and fourth regimes decreased auditor-subjects’ willing-
ness to issue biased reports, relative to the two regimes in which rotation was
not imposed. In these other two regimes, however, many manager-subjects
voluntarily retained the same auditor-subjects over multi-periods. While the
long running interactions between manager- and auditor-subjects resulted in
more favorable reports by auditor-subjects (a lower level of independence),
the established relationships also induced manager-subjects to make higher
investments.
∗ John M. Olin School of Business, Washington University. We appreciate the comments and
suggestions of Phil Berger, Mahendra Gupta, Dan Simunic, Geoffrey Sprinkle, and seminar par-
ticipants at the 1998 AAA Midwest Accounting meetings, the 1998 North American meetings of
the Economic Science Association, Arizona State University, University of Manitoba, University
of Southern California, and University of Wisconsin-Madison. In addition, we acknowledge the
assistance of Jim Holloway and Amy Choy in programming and data collection.
93
Copyright
C , University of Chicago on behalf of the Institute of Professional Accounting, 2001
94 N . DOPUCH , R . R . KING , AND R . SCHWARTZ
1. Introduction
In this paper, we provide results from an experiment designed to inves-
tigate how mandatory rotation and/or retention of auditors may increase
auditors’ independence. Mandatory rotation of auditors has been adopted
in several European countries (e.g., see Buijink et al. [1996]) as a means of
reducing threats to auditor independence arising from long-term relation-
ships between auditors and their clients. The imposition of this regulation
has been considered previously in the U.S. by several bodies (e.g., the United
States Senate’s Metcalf Subcommittee [1977], and the AICPA’s Cohen
Commission [1978]). More recently, mandatory rotation was included in
a bill introduced in the Senate Commerce Committee in 1994, and is one
of the topics of interest cited in the “Call for Research” announced in a
letter from the Chief Accountant of the SEC to the American Account-
ing Association (SEC [1999]). Under mandatory rotation, auditors would
have a limited time horizon to develop relationships that could potentially
impair their independence. Hence, they could have stronger incentives for
unbiased reporting.
Those who oppose mandatory rotation, such as audit firms and the AICPA,
argue that it would result in excessive switching costs and could also de-
crease audit quality. For example, the Cohen Commission [1978] noted that
more audit failures occurred in the early years of audit engagements,
rather than after auditors and clients had re-contracted for many years (see
Gietzmann and Sen [1997] for a discussion of this conclusion). Objections
to mandatory rotation are also provided in a recent General Accounting
Office publication (GAO [1996]) that studied various issues related to au-
ditor independence. The GAO concluded that the benefits from imposing
mandatory rotation of auditors after a set number of periods were insuf-
ficient to cover switching and other costs that would be incurred by audit
firms and their clients (Chapter 4, GAO [1996]).
It is difficult to obtain empirical evidence on the costs and benefits of a
proposed regulation prior to its implementation, especially the benefits.
For example, an implicit assumption underlying mandatory rotation of
auditors is that auditor independence would increase because the poten-
tial economic gains from future engagements with the same client would
be truncated at the rotation date. However, we are not aware of any em-
pirical study demonstrating that mandatory rotation significantly increases
auditor independence beyond that induced both by competitive audit
markets and by the legal liability imposed on auditors for inferior au-
dits.
We use experimental methods to investigate the potential benefits gained
from imposing mandatory rotation in an auditing regime. Experimental
methods are one means of conducting empirical studies of an issue when
studies using archival data are not feasible. The experimental method also
allows us to focus on the impact of mandatory rotation holding constant mar-
ket, legal, and other institutions that could constrain auditors’ willingness
RETENTION AND ROTATION REQUIREMENTS 95
to compromise their independence. In effect, we design a regime that

presents a strong incentive for the auditor to compromise independence,
and then examine whether a mandatory rotation requirement affects audi-
tor independence.1
Mandatory rotation may not necessarily improve auditors’ independence
during the periods prior to the rotation date since clients could threaten
to replace their auditors earlier than required. Therefore, in addition to
the rotation requirement we also investigate the effects of mandatory re-
tention, which requires the client to retain the incumbent auditor for a
pre-specified number of years. A coupling of mandatory retention with
mandatory rotation could protect the auditor against early dismissals, yet
truncate the economic benefits from repeat engagements.2 Mandatory re-
tention is required in a few European countries, either as an alternative to
mandatory rotation or as a complement.
We find that the imposition of mandatory rotation decreased auditor
subjects’ willingness to bias their reports in favor of management, relative
to the regime in which neither mandatory rotation nor mandatory reten-
tion was imposed. The lowest frequency of biased reports occurred in the
regime in which both retention and rotation were mandatory. These results
support the notion that mandatory rotation can increase auditors’ indepen-
dence.
2. The Current Debate on Auditor Independence

Our focus on auditors’ reporting is motivated by concerns voiced by the
Securities Exchange Commission (SEC) that the recent expansion of the
scope of audit services increases auditors’ incentives to bias their reports in
favor of management. For example, in a recent speech Chairman Arthur
Levitt [May 2000] stated that “. . . consulting and other services may shorten
the distance between the auditor and management. Independence—if not
in fact, then certainly in appearance—becomes a more elusive proposition.”
He went on to say, “. . . the audit is sometimes priced lower to attract clients
willing to pay for higher margin consulting services. . . I’m concerned that
the audit function is simply being used as a springboard to more lucrative
consulting services.”
The Independence Standards Board (ISB) was created in 1997 for the
purpose of setting new standards designed to strengthen auditor indepen-
dence (Schroeder [1997]). Although the ISB has the authority to issue new
1
We recognize that evidence from previous experimental studies indicates that the interac-
tions between market forces and legal sanctions generally lead to independent audits in the
absence of such mandatory rules. Nevertheless, mandatory rules are periodically proposed in
periods of suspected instances of compromises in auditor independence and remain in force
in several European Union countries.
2
Of course, a mandatory retention requirement could increase moral hazard of auditors
since they could shirk and still be retained by the client (ignoring legal and reputation costs).
rules and standards of independence, the board has been slow to do so. Re-
cently, the ISB issued a Discussion Memorandum that merely describes the
current status of its attempt to develop a conceptual framework for auditor
independence. Its focus on a conceptual framework reflects the ISB’s belief
that such a framework is a prerequisite to the development of additional
rules and regulations.
In contrast, the SEC has recently issued a proposal to revise its indepen-
dence requirements (SEC [ June 2000]). One of the revised rules would
prohibit audit firms from providing certain types of non-audit services
to their audit clients. In the document, the Commission states that an-
other option it has considered is the prohibition of all non-audit services
to audit clients. This would represent a rather extreme solution to the
independence problem, a solution the audit profession in general would
oppose.3 In a letter to Members of Congress Chairman Levitt clarifies that
“Under the rule proposal and the submission by PricewaterhouseCoopers
and Ernst & Young, firms would still be able to provide consulting services
to non-audit clients. This is where they derive the overwhelming majority
of their non-audit revenue. The proposal also does not prohibit most of the
services auditors perform for their audit clients. Rather, it identifies ten ser-
vices that impair independence, most of which are already prohibited under
current profession and SEC rules” [October 16, 2000].
While the provision of non-audit services may threaten auditor indepen-
dence, other phenomena may create a similar threat. For example, auditors
are alleged to quote fees lower than the marginal costs of initial engagements
with clients (a practice known as low-balling) in anticipation of declining
marginal costs of future audits of these clients. The incentive to compromise
independence in order to be rehired and benefit from these lower marginal
costs will not be reduced by a ban on non-audit services. In addition, such
a ban also ignores the possible synergies obtained from the joint provision
of audit and other kinds of services to audit clients.4
An alternative approach that might reduce threats to auditor indepen-
dence arising from the potential to earn economic rents from long-term
client engagements is to adopt the European requirement of mandatory
rotation. Although mandatory rotation would not completely eliminate the
threat to independence from non-audit services, it could reduce the severity
of the threat by truncating the economic benefits at the rotation date. The
3
We might add here that the Big 5 are split regarding the wisdom of such an overall ban,
with Ernst and Young and PriceWaterhouseCoopers in favor of the ban and the other three
against the ban. See Schroeder [August, 25, 2000]. In an experimental study, Dopuch and
King [1991] provide evidence that prohibiting auditors from providing both MAS and auditing
services to the same clients effectively encouraged auditor subjects to forego the audit in favor
of competing for the more profitable MAS contracts.
4
Dopuch, Gupta, Simunic, and Stein [1999] find that the ratio of actual fees received from
audit clients to the standard fees billed (called the realization rate) increases with higher levels
of management consulting and tax services.
TABLE 1
Notation and Parameter Values Used in the Experiment
Notation Value
Asset type ω HIGH; LOW
Manager’s investment choices:
Amount of investment I 50, 150, 700
Probability of a HIGH asset α 0.3, 0.5, 0.8
Signals that the auditor receives about the asset type ξ high; low
The probability that the signal is high given the asset is HIGH q .75
Auditor’s possible reports ρ Ĥ; L̂
Manager’s decision whether to dismiss an auditor who reports L̂ δ dismiss/retain
Manager’s setup costs when switching auditors S 100
The manager’s payoff when the auditor reports Ĥ MH 3,000
Manager’s payoff when the auditor reports L̂ ML 0
Auditor’s rents in periods or repeat engagement R 1,250
Auditor’s liability if a LOW asset is reported as Ĥ Y 1,500
extent to which the truncation of such benefits through mandatory rotation

of auditors does in fact improve auditor independence is the focus of this
paper.
3. Experimental Setting, Procedures, and Design

3.1 GENERAL SETTING
Our experiment consists of multi-period interactions between a manager
who invests in a risky asset and an auditor who issues a report about this
asset.5 The outcome of this asset, ω, (e.g., the present value of future cash
flows), can be HIGH or LOW, (hence, ω ∈ {HIGH, LOW }). At the beginning
of each period the manager makes an investment decision, I, that determines
the probability of producing a HIGH asset, α ∈ (0, 1). Higher probabilities
of a HIGH asset require higher amounts of investment. That is, I (α) is
increasing in α. In the experiment manager-subjects can choose among
three levels of α—0.3, 0.5, and 0.8, requiring investment amounts of 50, 150,
and 700, respectively. Table 1 summarizes the notation and the parameter
values used in the experiment.
The manager hires an auditor to credibly communicate the type of asset.
The auditor is paid a flat fee,6 and employs an audit technology of quality
q that has a one-sided error. If the asset is LOW, the audit always produces
a low signal, but if the asset is HIGH, the audit produces a high signal with
5
Related research that explores auditors’ independence includes Antle [1984], Antle et al.
[1997], Magee and Tseng [1990], Simunic [1994], and Teoh [1994].
6
We did not incorporate a formal bidding process in order to simplify the setting for the
subjects. This allows us to focus cleanly on auditor reporting, without adding undue complexity
to the environment. For research addressing the bidding process in experimental settings, see
Calegari, Schatzberg, and Sevcik [1998], Kachelmeier [1991], and Dopuch and King [1996].
probability q, and a low signal with probability 1 − q.7 We assume an exoge-

nous audit technology in order to focus on the auditor’s reporting strategies,
rather than on effort choices. The auditor observes the signal, ξ ∈ {high, low},
and issues a report, ρ ∈ { Ĥ, L̂}. An erroneous Ĥ report is discovered at the
end of the period and the auditor pays a legal penalty. The auditor’s report
also has consequences for the manager’s compensation: An Ĥ report results
in a higher compensation for the manager than an L̂ report. After observing
the auditor’s report, the manager chooses to retain the incumbent auditor
for another period (if rotation is not required), or to replace him (if reten-
tion is not required). A manager who dismisses an auditor incurs a setup
cost, S, in the first period of the new audit engagement.
If the manager retains the auditor, the auditor receives economic rents,
R, in every period of a repeat audit engagement. These rents can repre-
sent savings from declining marginal costs, or synergies between audit and
non-audit services provided by the auditor. Since the receipt of these rents
depends on the manager rehiring the auditor, the manager could try to
influence the auditor’s reporting strategy by threatening to terminate an
auditor who reports L̂. We assume that all economic rents are captured by
the auditor in order to increase the credibility of the manager’s dismissal
threat, thus leading to a potential lack of independence.8
Figure 1 presents the game tree of the interactions between managers
and auditors, and summarizes their payoffs.
Since our focus is on the extent to which rotation and retention enhance
auditor independence, we created an experimental setting in which auditor-
subjects had an incentive to compromised independence. An auditor who
issued an Ĥ report could not be dismissed (unless rotation is required),
thereby guaranteeing a repeat audit engagement and economic rents to an
auditor who reports favorably.
3.2 EXPERIMENTAL DESIGN AND PROCEDURES

We investigate four different experimental regimes. The first regime is
similar to existing practice in that neither mandatory rotation nor manda-
tory retention is required. In this setting the manager can choose either to
dismiss or retain the auditor at the end of any period for which the auditor
reports L̂. An auditor who is dismissed loses rents for at least one period,
7
Audit quality was exogenous because our focus in this paper is on issues of independence
as reflected by the reporting choices that auditors make.
8
We designed the manager’s compensation to depend solely on the auditor’s report in order
to provide the manager with the strongest incentive to try to induce the auditor to report Ĥ. A
compensation scheme that also depends on other factors (e.g., the underlying quality of audit,
or the probability of a HIGH asset) would reduce the manager’s incentive to induce Ĥ reports.
Thus, our setting provided the manager with the strongest incentive to employ an auditor who
will issue Ĥ reports (which was the primary focus of our study).
FIG.1.—A game tree of the interactions between managers and auditors, and a summary
of payoffs.
even if rehired immediately by a new manager. In the second regime the

manager must retain the auditor for a minimum of three periods regardless
of the auditor’s report, after which the manager can dismiss the auditor
if an L̂ report is issued. The retention requirement provides a guarantee
that the auditor can earn at least two periods of rents, thereby reducing the
auditor’s incentive to compromise independence in these periods. A third
regime does not have a minimum retention requirement, but the auditor
has to be rotated at the end of the fourth period, thereby reducing his in-
centive to compromise independence. In our fourth regime we couple the
mandatory retention of three periods with a mandatory rotation after the
fourth period. This allows the manager to voluntarily dismiss the auditor
only at the end of the third period. The experimental design is a 2 × 2 as

summarized below:
Experimental Design
No Retention Retention for three periods
No Rotation NoRetention/NoRotation Retention
Rotation after Rotation Retention/Rotation

four periods
We conducted three sessions in each of the four regimes, for a total of

12 sessions. Each session had twelve subjects, with six playing the role of an
auditor and six playing the role of a manager. Thus, a total of 144 subjects
participated in the experiment.
Subjects initially received instructions and then were randomly assigned
their roles as either a manager or an auditor, which they maintain for all
periods.9 Subjects were informed that the experiment would run for at least
25 periods, after which an ending period would be determined randomly.10
The sessions had an uncertain end point in order to reduce the possible
backward induction effect of a known endpoint for regimes with no rota-
tion. The sequence of steps detailing the interactions between the auditor-
subjects and the manager-subjects is summarized below:
Step 1. Each of the six managers is randomly paired with an auditor.

Step 2. Each manager makes an investment decision (50, 150, or 700),
that determines the probability of a HIGH asset (0.3, 0.5, or 0.8
respectively).
Step 3. The computer determines the asset type based on the manager’s
investment choice.
Step 4. The computer generates a signal, high or low, consistent with the
audit technology, which was set to q = 0.75. Since a high signal
could only be generated when the asset was HIGH, every high
signal triggers a computerized Ĥ report and the period ends. If
the signal is low, it is reported to the auditor.
Step 5. When the auditor-subjects observe a low signal, they also receive
the conditional probability that the asset is HIGH, calculated us-
)·α 0.25 · α
ing the Bayes’ rule as follows: (1−q 1−q · α
= 1−0.75 ·α
. Specifically,
when managers choose α = 0.3 (0.5, 0.8), auditors who observe a
low signal are informed that the ex post probability that the asset is
9
Market interactions were implemented on networked PCs. Instructions are available upon
request. Throughout the instructions and actual experiment, all participants were monitored
to prevent communication with each other.
10
Due to a computer malfunction, one session in the Retention regime had only 23 periods.
The total number of periods for the other three regimes ranged between 27 and 33.
HIGH is 10% (20%, 50%, respectively).11 By informing auditors

about the underlying probability we obtain a clearer measure of
their independence in reporting, since their reporting decisions
should not be influenced by errors in estimating the manager’s
actions.
Step 6. The auditor chooses a report, Ĥ or L̂. If the auditor reports Ĥ,
the period ends.
Step 7. If the auditor issues an L̂ report, the manager decides whether
to dismiss the auditor or retain him, unless retention or rota-
tion is required. Once a manager dismisses an auditor, all subse-
quent auditors interacting with that manager are informed that
the manager has dismissed an auditor. The formation of such a
reputation increases the credibility of the dismissal threat, which
is necessary to create an incentive to compromise independence.
Step 8. At the end of each period, payoffs are realized and reported to
the subjects. Managers receive MH = 3,000 if the audit report is
Ĥ, and ML = 0 if the audit report is L̂, minus setup cost of
S = 100 at the initial period of an audit engagement with a new
auditor. Auditors pay a legal penalty of Y = 1, 500 if they re-
port a LOW asset as Ĥ; auditors also receive rents of R = 1,250
in every period of a repeat audit engagement with the same
manager.
In the experiment, a manager who dismissed an auditor was randomly
matched with a different auditor. The matching process gave the manager
a 90% probability of being matched with any unemployed auditor (if there
were unemployed auditors), and a 10% probability of being matched with
an employed auditor. Subjects knew the process for re-matching, although
they did not know these probabilities. Subjects also knew that auditors were
never matched with more than two managers at any period, and that an
auditor was never re-matched with a manager who had just dismissed him.12
This matching procedure prevented the case where managers would always
be matched with auditors who were dismissed for reporting L̂ (which could
have reduced managers’ incentives to replace their auditors).
4. Strategies and Hypotheses

4.1 THE AUDITOR’S REPORTING STRATEGY
Since the audit technology is exogenous and fixed in all regimes, the
auditor-subjects only make reporting decisions. The auditor’s reporting
11
The probability of a LOW asset is (1 − α)/(1 − αq). For example, when α = 0.3, the calcu-
lations are (1 − 0.3)/(1 − 0.3 × 0.75) = 0.9, generating the probability of a HIGH asset as 0.1.
12
We employed those probabilities in the re-matching process so that auditors would be
re-employed after only a few periods, thereby maintaining their interest and connection to
the game. Based on ex post questionnaires, subjects indicated a full understanding of this re-
matching process and there were no concerns expressed about it.
choice of Ĥ or L̂ is made after observing a low signal and learning the

posterior probability that the asset is HIGH. The auditor weighs the costs
and benefits of each of the two reports and then selects the reporting choice
that maximizes his expected utility. The cost of issuing an Ĥ report is the
expected liability if the asset is LOW, and the benefit is the rent received by
being rehired by the manager. The benefit to the auditor from issuing an L̂
report is the avoidance of a potential liability, but the downside of issuing
an L̂ report is the possibility of losing next period’s rent if dismissed by the
manager. Thus, we predict that if the auditor subject makes choices that
maximize his expected payoffs, an auditor who is not facing a mandatory re-
tention or rotation requirement at the end of the period will report Ĥ after
receiving a low signal if the future rents exceed the expected liability costs
1−α
(formally, 1−αq Y ≤ R). The reporting rule collapses into a critical value of
α. If the manager chooses an investment probability that is below the criti-
−R
cal value, α < YY−q R
, the auditor reports L̂, but, if the manager chooses an
−R
investment that is equal to or exceeds the critical value, α ≥ YY−q R
and the
manager can dismiss the auditor, an auditor who maximizes expected pay-
offs should report Ĥ. In the experiment, that critical value was 0.444. Hence,
auditors who face a dismissal threat have higher expected net payoffs if they
report favorably if and only if managers chose investment probabilities of
0.5 or 0.8, higher than the critical value of 0.444.
The manager cannot threaten the auditor with dismissal in a retention
period, since the auditor must be retained for another period. Hence the
auditor’s rents are guaranteed. Thus, the auditor maximizes payoffs in a
retention period by reporting L̂ since this removes all liability risks. In like
fashion, if replacement is inevitable because of an imposed rotation rule,
the auditor maximizes payoffs by reporting L̂, knowing that rents cannot
be received even if he reports Ĥ. Implicit in this prediction is that auditors
will report Ĥ more frequently in periods when dismissal by the manager is
allowed.
Previous experimental research has shown that game theory is often a rea-
sonable predictor of behavior in auditing settings. However, Kachelmeier
[1996] argues that the predictive accuracy of game theory models by non-
economic factors. As an example, Bloomfield [1995, 1997] shows that the
structure of the game setting may influence how closely players are able
to achieve the equilibrium depends on whether players converge to an
equilibrium inductively (through trial-and-error or adaptive learning) or
deductively (as in the inferential process of a game theorist). Based on the
arguments of Kachelmeier [1996] and Bloomfield [1997] our hypotheses
are based on both economic and behavioral models. If the auditor derives
his utility not only from his expected payoffs, but also from issuing reports
that match the posterior probabilities of the asset types, then we would ex-
pect that auditor subjects would report in a manner that approximates the
ex post probabilities of a HIGH or LOW asset. In a sense, this perspective
assumes auditors will report their beliefs about the type of asset, as in Magee
and Tseng [1990]. Moreover, in regimes with no rotation requirement,
auditors and managers can interact over a longer time horizon. Over that
longer horizon the auditor could generate higher expected benefits from
cooperation with a manager. Hence, we may observe more favorable report-
ing in the NoRetention/NoRotation regime and the later periods in the
Retention regime arising from the potential for reciprocity. Hypotheses 1
and 2 summarize our hypotheses.
HYPOTHESIS 1. Auditors’ Reporting
a. Expected Payoffs Maximization: Auditors will report Ĥ more fre-
quently in periods when dismissal by the manager is allowed.
b. Auditors will report Ĥ in a manner that approximates the ex post
probability of a HIGH asset.
HYPOTHESIS 2. Auditors’ Independence
Auditors will compromise their independence most often in the
NoRetention/NoRotation regime, and least often in the Retention/
Rotation regime. Specifically, the frequency of favorable reports will
exceed the probability of a HIGH asset most often in the NoReten-
tion/NoRotation regime, followed by the Retention regime, the Ro-
tation regime, and least often in the Retention/Rotation regime.
Formally,
BiasNoRetention/NoRotation > BiasRetention > BiasRotation

> BiasRetention/Rotation ,
where the Biasregime measure is equal to the frequency of Ĥ reports
issued by auditors minus the posterior probabilities that the assets
are HIGH.
4.2 THE MANAGER’S DISMISSAL AND INVESTMENT STRATEGY

In order to induce the auditor to issue an Ĥ report, which generates
higher payoffs for the manager, the manager must create a credible threat
of dismissal. A replacement threat can be credible only if it would be ex
post rational for the manager to carry it out. The manager is predicted
to replace the auditor if the setup cost that will have to be incurred with
the new auditor, S, is lower than the expected benefit from replacement.
The expected benefit derives from the manager forming a reputation for
dismissing auditors who report L̂. (In the experiment, whenever a manager
dismissed an auditor the information was made known to all subsequent
auditors matched with this manager in order to enhance the credibility
of the dismissal threat.) The increase in the manager’s expected payoff is
the difference between his payoffs if the auditor reports Ĥ (MH ), and the
payoffs if the auditor reports L̂ (ML ), multiplied by the probability that
the auditor receives a low signal and reports Ĥ. Formally, the increase in
expected payoffs due to a credible threat is (MH − ML )(1 − αq ). Hence,
the manager’s replacement strategy is to replace an auditor who reports L̂,
if S < (MH − ML )(1 − αq ). Given the experimental parameters, the setup

costs of 100 are sufficiently low to create a credible replacement threat at
all levels of α.
We hypothesize that managers will use dismissal and investment as sub-
stitutes. Therefore, in periods that allow the managers to dismiss an audi-
tor, managers will invest a lower amount and induce a favorable report by
creating a credible dismissal rate. In rotation or retention periods, where
dismissal by the manager is not allowed, managers will choose a higher level
of investment, which results in a higher probability of a HIGH asset, thereby
increasing the probability of an Ĥ report and higher payoffs. The behav-
ioral approach provides a competing hypothesis—regimes with no rotation
requirement allow for a longer horizon over which the manager interacts
with the same auditor. Thus these regimes may encourage reciprocity, in
which case we expect the manager to invest more in order to lower the au-
ditor’s expected liability when he reports favorably. These predictions are
summarized in hypothesis 3.
HYPOTHESIS 3. Managers’ Dismissal and Investment Strategies
a. Economic prediction: Managers use dismissals and investments as

substitutes. Hence, in periods where dismissal is allowed managers
will dismiss auditors who report L̂, and invest less. Managers will
invest more in periods of retention or rotation when dismissal is not
allowed.
b. Behavioral prediction: Managers will dismiss less and invest more in
regimes in which no rotation is required.
5. Results—Auditors’ Reporting and Independence

Our main focus is the extent to which mandatory retention and/or rota-
tion increase auditors’ independence. We assume that increased indepen-
dence is reflected in lower frequencies of auditors’ reports that are biased
in favor of management. Recall that the audit technology is such that the
auditor can receive low signals from both HIGH assets and LOW assets. The
first assessment in this section consists of a comparison or the relative fre-
quencies of auditors’ Ĥ reports, after they observed a low signal, across the
four different regimes. These frequencies are reported in Panels A through
D of table 2. Next we compare the degree of bias in auditors’ Ĥ reports,
where bias is defined as the difference between the frequency of Ĥ reports
issued and the ex post probabilities that the assets generating the low signal
are really HIGH assets. The bias measures appear in Panels A through D
of table 3. Finally, we regress variables that might explain auditors’ report-
ing choices on the decision to issue Ĥ reports, beyond the effects of the
rotation and retention requirements per se. The regression results appear in
table 4.
TABLE 2
Frequency of Ĥ Reports Issued by Auditors After Receiving a low Signal

Posterior Neither
probability of Rotation nor Retention and
a HIGH Asset Retention Retention Rotation Rotation
Panel A: All periods
10% 25/59 (42%) 6/23 (26%) 2/39 (5%) 0/30 (0%)
20% 46/91 (51%) 26/88 (27%) 21/128 (18%) 3/94 (3%)
50% 106/125 (85%) 74/93 (80%) 48/96 (50%) 45/127 (35%)
Panel B: Periods where dismissal by the manager is allowed
10% 25/59 (42%) 5/15 (33%) 2/27 (7%) 0/11 (0%)
20% 46/91 (51%) 25/76 (33%) 19/107 (18%) 1/36 (3%)
50% 106/125 (85%) 65/83 (78%) 44/80 (55%) 13/22 (59%)
Panel C: Periods where Rotation must occur at the end of the period
10% 0/12 (0%) 0/5 (0%)
20% 2/21 (10%) 0/15 (0%)
50% 4/16 (25%) 4/21 (19%)
Panel D: Periods where the auditor must be retained regardless of report
10% 1/8 (13%) 0/14 (0%)
20% 1/12 (5%) 2/43 (5%)
50% 9/10 (90%) 28/86 (33%)
Note. The left column details the posterior probabilities of a HIGH assets, which are known to the auditor-
subjects prior to making their reporting choices. The other columns present the number of times that the
auditors issue a favorable report after observing a low signal, divided by the total number of low signals that
the auditors observed (frequencies appearing in parentheses). A comparison of the frequencies of favorable
reports to the posterior probability of a HIGH asset is the basis for defining bias in auditors’ reporting.
5.1 FREQUENCIES OF Ĥ REPORTS

The left column in table 2 presents the posterior probabilities of a HIGH
asset, while the other four columns present the frequencies of Ĥ reports
for the four regimes. Panel A provides these frequencies for all periods in
each regime. Generally, the frequencies of favorable reports decline as we
move from the regime with no requirements to the retention regime, to the
rotation regime, and finally to the regime that imposes both retention and
rotation.
The data reported in Panel B are the frequencies of favorable reports in
periods in which dismissal was allowed. Obviously, the frequencies for the
first regime remain the same since dismissal was allowed in all periods. As
expected, the frequencies are slightly higher for the other three regimes
in those periods in which the managers could threaten to dismiss their
auditors, particularly for the regimes that imposed a rotation requirement
at the end of the fourth period. Panels C and D provide the frequencies
of favorable reports in periods in which rotation was mandatory (Panel C)
and when retention was mandatory (Panel D). In general, the frequencies
in Panel C are lower than in any of the other Panels.
Recall that hypothesis 1a predicts that auditors will provide favorable re-
ports more frequently in periods when dismissal is allowed (Panel B) relative
to the frequencies in periods in which either mandatory rotation and/or

retention were required (Panels C and D). A test of proportions supports
hypothesis 1a (p < 0.01).
5.2 BIAS IN AUDITORS’ REPORTING

Our second assessment of the effects of mandatory rotation and re-
tention on auditor independence is based on the extent to which the
frequencies of favorable reports mirror the ex post probabilities of a HIGH
asset. Hypothesis 1b predicts that auditors will provide favorable reports
consistent with these ex post probabilities, which we define here as providing
unbiased reports. Referring back to table 2, we note that auditor subjects
selected favorable reports which generally exceeded the ex post probabili-
ties of HIGH assets. This was especially true in the regime which required
neither rotation nor retention, where favorable reports were issued with
frequencies of 42%, 51%, and 85% for the three ex post probabilities of
10%, 20%, and 50%, respectively. The frequencies of favorable reports were
only slightly lower in the retention, which had frequencies of 33%, 33%,
and 78% for the three respective ex post probabilities. In fact, only the fre-
quencies of favorable reports shown for the rotation regime were close to
the underlying probabilities—5%, 18%, and 50%, respectively. Note that
the frequencies of favorable reports in the regime which required both
retention and rotation were actually lower (more conservative) than the
ex post probabilities. Hence, the overall results provide weak support of
hypothesis 1b.
Summary measures of bias for the four regimes are provided in table 3.
The summary measures were calculated by computing a weighted average of
the differences between the frequency of Ĥ reports and the ex post probabil-
ities, using weights based on the total number of reports issued by auditors.
For example, in the regime where neither rotation nor retention was re-
quired, auditors issued a total of 275 reports. Out of these 275, auditors
were informed in 59 cases that the ex post probability of a HIGH asset was
10% and then issued 25 Ĥ reports (or 42%), leading to a bias of 32%. In
91 cases after auditors were informed that the ex post probability was 20%,
they issued 46 Ĥ reports (or 51%), leading to a bias of 31%. In the re-
maining 125 cases when auditors were informed that the ex post probability
was 50%, they issued 106 Ĥ reports (or 85%) leading to a bias of 35%.
The mean (weighted average) bias is 59/275 × 32% + 91/275 × 31% + 125/
275 × 35% = 33.03%. The mean biases for the other regimes are also shown
in table 3, along with P-values, and the number of observations for the four
regimes. As in table 2, Panel A presents results for all periods, Panel B for
periods where dismissal was allowed, Panel C for the rotation periods, and
Panel D for the retention periods.
Hypothesis 2 states that auditors will compromise their independence
most often in the NoRetention/NoRotation regime, and least often in
the Retention/Rotation regime. A formal test of hypothesis 2 consists of
a relative comparison the mean biases in the four regimes using data
from all periods (Panel A). We find that the mean bias of 33.03% in
the NoRetention/NoRotation regime was significantly higher than the
mean biases in all other regimes ( p < 0.001), and that the mean bias of
−15.15% in the Retention/Rotation regime was significantly lower than
the mean bias in the other three regimes ( p < 0.001). We also find that
the mean bias of −1.71% in the Rotation regime was significantly lower
than the mean bias of 18.5% in the retention regime, ( p < 0.001). These
findings are consistent with hypothesis 2, supporting the conclusion that
mandatory retention coupled with mandatory retention increased auditors’
independence.
Panel B of table 3 presents the mean bias in auditors’ reporting in periods
when managers could dismiss auditors who issued L̂ reports. A comparison
of the biases across the four regimes indicates that rotation and/or reten-
tion requirements affected auditors’ reporting even in periods in which
these requirements were not in effect. In particular, we find the lowest
mean bias in the Retention/Rotation regime (−7.59%), the second low-
est bias in the Rotation Regime (0.49%), a significantly higher bias in
the Retention regime (21.02%), and finally the highest mean bias in the
TABLE 3
Summary of Bias in Auditors’ Reporting
Neither Rotation Retention and
nor Retention Retention Rotation Rotation
Mean Bias +33.03%+++ +18.5% −1.71%^^^ −15.15%∗∗∗
( p-Value) (0.000) (0.000) (0.046) (0.000)
(N ) (275) (204) (263) (251)
Mean Bias +33.03%+++ +21.02% +0.49%^^^ −7.59%∗∗∗
( p-Value) (0.000) (0.000) (0.021) (0.000)
(N ) (275) (174) (214) (69)
Mean Bias −14.90% −24.22%∗∗∗
( p-Value) (0.019) (0.000)
(N ) (49) (41)
Mean Bias +8.13% −15.71%∗∗∗
( p-Value) (0.472) (0.000)
(N ) (30) 7 (141)
∗∗∗
Significantly lower than all other regimes, p < 0.001.
+++
Significantly higher than all other regimes, p < 0.001.
^^^Significantly lower than the Retention regime, p < 0.001.
Note. The mean bias is the weighted average of the differences between the frequency of Ĥ reports and
the ex post probabilities, using weights based on the total number of reports issued by auditors. Bias is defined
as the difference between the frequency of Ĥ reports (from Table 2), and the posterior probability of a
HIGH asset. For example, in the regime where neither rotation nor retention is required, auditors issued
a total of 275 reports. In 59 cases the ex post probability of a HIGH asset was 10%, but the auditors issued
25 favorable reports (42%) leading to a bias of 32%. In 91 cases the bias was 31%, and in the remaining
125 cases the bias was 35%. The weighted average bias is 59/275 × 32% + 91/275 × 31% + 125/275 × 35% =
33.03%.
NoRetention/NoRotation regime (33.03%). We repeat the comparison for

periods in which either rotation or retention is in effect (Panels C and D,
respectively) and find similar results.
The overall results on bias in the different regimes are consistent with
the following inferences. The high positive bias of 33.03% observed for the
NoRetention/NoRotation regime was progressively eliminated as we first
imposed the retention requirement (down to 18.5%), then after imposing
the rotation requirement (down to −1.71%), and then more than offset after
imposing both requirements. That is, the imposition of both requirements
resulted in a negative bias of −15.15%. Our results suggest that if the goal of
policy makers is to reduce the independence-compromising impact of con-
tingent rents, while still maintaining bias-free reporting strategies, the goal
could be achieved by the imposition of the rotation requirement by itself.
5.3 REGRESSION RESULTS FOR AUDITORS’ REPORTING CHOICES
Our final analysis consists of an assessment of whether auditors’ reporting
choices might have been influenced by factors beyond the mandatory ro-
tation and retention requirements. To do this, we regress auditors’ choices
on the following plausible explanatory variables. The results are reported
in table 4 for each of the four regimes. The dependent variable is REPORTt
which takes the value 1 if the auditor issues an Ĥ report in periods t and 0
if the auditor issues an L̂ report. Our first independent variable is INVESTt ,
which is the investment choice made by the manager in period t. We hy-
pothesize a positive coefficient because a higher level of investment implies
a higher probability that the asset is HIGH, and hence a lower expected lia-
bility. PREV LOW t is the proportion of L̂ reports that an auditor issued in
previous periods. This is a crude proxy for auditor type, and we hypothesize
a negative coefficient. IDLEt is the proportion of periods that the auditor
was idle out of all previous periods, and we hypothesize a positive coefficient
based on the assumption that an auditor who has been idle would be more
likely to issue favorable reports in order to avoid future dismissals. Lastly, D 1
and D 2 are dummy variables, where D 1 is equal to 1 if retention is required
at the end of the period, and D 2 is equal to 1 if rotation is required at the
end of the period. We hypothesize negative coefficients for both dummies,
because an auditor has weaker incentives to issue a favorable report when
either he is guaranteed rents in a retention period, or the mandatory rota-
tion prevents him from receiving any rents in the next period. The results
are reported in table 4 for each of the four regimes.
The regression produces a positive and significant coefficient on INVEST
in all four regimes ( p < 0.01) as hypothesized, and consistent with the in-
creased frequencies of favorable reports for higher levels of investment ob-
served in table 2. As mentioned above, higher levels of investment reduced
the auditors’ exposure to legal penalties. A negative coefficient is estimated
for the variable, PREV LOW, in the two regimes that did not have a rotation
requirement, indicating that auditors were less likely to issue a favorable
report if they previously issued a high percentage of unfavorable reports.
TABLE 4
Regression Results for Auditors’ Reporting Choices
REPORTt = β0 + β1 × INVESTt + β2 × PREV LO W t + β3 × IDLEt + β4 × D 1 + β5 × D 2 + ε
Neither
Predicted Rotation Rotation and
Sign Nor Retention Retention Rotation Retention
Intercept 0.17∗∗ −0.16 −0.16 −0.24∗∗
( p-Value) (0.05) (0.19) (0.13) (0.02)
INVEST 1.01∗∗∗ 1.32∗∗∗ 0.98∗∗∗ 0.93∗∗∗
( p-Value) + (0.00) (0.00) (0.00) (0.00)
PREV− LOW − −0.49∗∗∗ −0.29∗∗∗ −0.15 −0.08
( p-Value) (0.00) (0.00) (0.11) (0.29)
IDLE + 0.52∗∗∗ 0.87∗∗ −0.16 −0.52
( p-Value) (0.00) (0.03) (0.62) (0.11)
D1 − −0.18∗∗ −0.07
( p-Value) (0.02) (0.22)
D2 − −0.16∗∗ −0.17∗∗
( p-Value) (0.01) (0.02)
Adj. R2 22.19% 28.47% 17.16% 18.34%
(F -Score) (0.00) (0.00) (0.00) (0.00)
(N) (275) (204) (263) (251)
REPORTt = 1 if the auditor reports Ĥ in period t and 0 if the auditor reports L̂ in period t.
IN VESTt = the investment choice made by the manager at period t.
PREV− LOWt = the proportion of L̂ reports out of the total reports that an auditor issued in periods 1
through t − 1.
IDL E t = the proportion of periods that the auditor was idle out of periods 1 through t − 1.
D 1 = 1 if retention is required at period t; 0 otherwise.
D 2 = 1 if rotation is required at the end of period t; 0 otherwise.
∗∗∗
Significant at p < 0.01.
∗∗
Note. Auditors’ reporting choices are regressed on variables which might affect auditors’ reporting
strategies. Specifically.
Hence, there seemed to be an auditor type effect, with some auditors less
likely to issue favorable reports and some auditors more likely to do so.
The variable, IDLE, has a positive coefficient in the same two non- rotation
regimes, suggesting that auditors who were idle in previous periods were
more likely to issue a favorable report in order to avoid further dismissals.
The fact that the coefficients for PREV LOW and IDLE in the Rotation and
Retention/Rotation regimes are insignificant is consistent with the notion
that the rotation requirement did not allow sufficient numbers of periods
for the development of long term relationships between auditors and man-
agers. This is confirmed by the negative coefficient for the rotation dummy
variable, D 2 in both regimes. The result is also consistent with the spillover
effect of the rotation requirement observed in table 3. Note also that the
coefficient for the retention dummy variable, D 1 , is negative for the reten-
tion regime, but not for the Retention/Rotation regime. This too is consis-
tent with the slight degree of spillover reported in table 3 for the retention
regime (i.e., a lower degree of positive bias). However, the coefficient for the
retention variable is overwhelmed by the negative bias the rotation exerts in
this regime.
Summarizing, the results consistently show that the rotation requirement

can increase auditor independence, which we define as lower frequencies
of reports that are biased in favor of management. In the next section,
we explore some of the effects of the rotation and retention requirements
on managers’ investment and dismissal strategies and how these may have
interacted with auditor subjects’ reporting strategies.
6. Results—Managers’ Investment and Dismissal Choices

Hypothesis 3a, which is based on an economic perspective, predicts that
managers will use dismissals and investments as substitutes. Hence, in peri-
ods in which dismissal is allowed, managers will dismiss auditors who report
L̂, and invest less. Managers will invest more in periods of retention or
rotation where dismissal is not allowed. Hypothesis 3b, in partial contrast,
predicts that managers will try to establish long-term relationships in the two
regimes that do not have rotation requirements by dismissing less and invest-
ing more in the non-retention periods even though dismissal is allowed in
those periods. We first present summaries of managers’ investment choices
in the different regimes.
6.1 MANAGERS’ INVESTMENT CHOICES

Recall that the three investment choices available to managers were to in-
vest 50 that would generate a HIGH asset with probability 0.3, invest 150 that
would generate a HIGH asset with probability 0.5, or invest 700 that would
generate a HIGH asset with probability 0.8. From an economic perspective,
managers would maximize their expected payoffs by choosing investment
levels that are high enough to induce auditors to issue Ĥ reports. Based
on our parameter values, this could be achieved by selecting an investment
level of 0.5 in periods in which the managers could dismiss the auditors,
and by selecting an investment level of 0.8 in periods in which managers
could not voluntarily dismiss the auditors. Table 5 shows the investment
choices by managers for each of the four regimes for the three investment
levels. As before, Panel A presents data from all periods, Panel B for periods
when managers could dismiss auditors who issued an L̂ report, Panel C for
rotation periods, and Panel D for retention periods.
Panel A shows that the investment levels chosen by the managers in the
NoRetention/NoRotation regime were 13% (73/540), 26% (140/540), and
61% (327/540) for the three investment levels, respectively. The corre-
sponding percentages for the Retention regime were 6% (28/468), 34%
(161/468), and 60% (279/468), respectively. The percentages for the other
two regimes were 11% (55/503), 44% (221/503), and 45% (227/503),
respectively; and 8% (42/528), 20% (154/528), and 63% (332/528),
respectively.
The patterns or choices shown in Panel B are similar, except for the Re-
tention/Rotation regime. In that regime, managers chose the middle invest-
ment level more often in periods when the auditor could be dismissed—50%
TABLE 5
Investment Choices by Managers
Investment nor Retention Retention Rotation Rotation
50 (0.3) 73 (13%) 28 (6%) 55 (11%) 42 (8%)
150 (0.5) 140 (26%) 161 (34%) 221 (44%) 154 (20%)
700 (0.8) 327 (61%) 279 (60%) 227 (45%) 334 (63%)
50 (0.3) 73 (13%) 19 (5%) 38 (9%) 15 (11%)
150 (0.5) 140 (26%) 127 (32%) 189 (45%) 56 (40%)
700 (0.8) 327 (61%) 246 (63%) 189 (46%) 68 (49%)
50 (0.3) 17 (20%) 7 (7%)
150 (0.5) 32 (37%) 27 (26%)
700 (0.8) 38 (43%) 68 (67%)
50 (0.3) 9 (12%) 20 (7%)
150 (0.5) 34 (45%) 71 (25%)
700 (0.8) 33 (43%) 198 (68%)
Note. The left hand column presents the investment amounts and the resulting ex ante probabilities that
the investment will yield a HIGH asset. The number of times each investment level was chosen is presented
for each regime, with frequencies reported in parentheses.
(56/139) instead of 20% before—and fewer choices of the highest invest-

ment level—49% (68/139) instead of 63% before.
It is clear from Panel B of table 5 that instead of selecting the 0.5 invest-
ment level predicted for dismissal periods, managers selected the higher
(0.8) level 61%, 63%, 46%, and 49% of the time in the four regimes. In
contrast, managers made fewer selections of the higher investment level
than expected in the Rotation periods (Panel C) and the Retention Peri-
ods (Panel D), or periods in which auditors could issue L̂ reports without
the fear of voluntary dismissals. The higher investment level would have
raised the ex post probability that the low signal received by the auditor was
generated by a HIGH asset.
In order to test hypotheses 3a and 3b, we compare the average investment
cost for the four regimes in periods when dismissals were and were not
allowed. Table 6 presents the mean investment and the dismissal choices for
each of the four regimes. As before, Panel A shows the average investment
costs and standard errors when aggregating over all periods. The data show
that the highest mean investment over all periods, 487.88 (standard error
of 12.08), occurred in the Retention/Rotation regime. The average cost for
the NoRetention/NoRotation regime of 469.54 (standard error of 12.37)
was statistically equal to the average cost of 471.90 (standard error of 12.87)
observed for the Retention regime. The lowest mean investment, 387.28
(standard error of 12.73), occurred in the Rotation regime.
Panel B presents investment and dismissal choices in periods where dis-
missal was allowed for all four regimes. The data indicate that managers
TABLE 6
Summary of Investment and Dismissal Choices by Managers
nor Retention Retention Rotation Rotation
Mean Investment 469.54 471.90 387.28∗∗∗ 487.88
(Std. Error) (12.37) (12.87) (12.73) (12.08)
(N) (540) (468) (503) (530)
Mean Investment 469.54 596.15+++ 390.75∗∗∗ 408.27∗∗
(Std. Error) (12.37) (13.01) (13.92) (24.43)
(N) (540) (392) (416) (139)
Dismissals/L̂ reports 41/98 20/79 67/149 30/55
(Proportion) (42%) (27%)∗∗∗ (45%) (55%)+
Mean Investment 370.69 509.8+++
(Std. Error) (31.51) (26.86)
(N) (87) (102)
Mean Investment 376.97 519.80+++
(Std. Error) (32.87) (15.71)
(N) (76) (289)
∗∗∗
Significantly lower than the other regimes, p < 0.001.
∗∗
Significantly lower than the regime with neither rotation nor retention, p < 0.05.
+
Significantly higher than the other regimes, p < 0.10.
+++
Significantly higher than the other regimes, p < 0.001.
Note. This table summarizes the average level of investment for each regime (based on table 5) and the
proportion of dismissal choices made by managers out of the total opportunities to dismiss an auditor who
issued an L̂ report. For example, out of the 540 investment choices in the NoRetention/NoRotation regime,
in 73 cases managers chose to invest 50, in 140 cases managers invested 150, and in 327 cases managers
invested 700, giving rise to an average investment of 469.54, and a standard error of 12.37. Of the total 540
investment choices, managers received 98 L̂ reports, and chose to dismiss the auditor in 48 cases, or 42%.
had an average investment cost of 469.54 and dismissed auditors 41/

98 times (42%) in the NoRetention/NoRotation regime; they had an av-
erage investment cost of 596.15 and dismissed auditors 20/79 times (27%)
in the Retention regime; they had an average investment cost of 390.75 and
dismissed auditors 67/149 (45%) in the Rotation regime; and had an aver-
age investment cost of 408.27 and dismissed auditors 30/55 (55%) in the
Retention/Rotation regime.
Panels C and D summarize the investment choices made in the rotation
and retention periods, respectively, when voluntary dismissals were not al-
lowed. Although the average investment costs shown in Panels C (Rotation
periods) and D (Retention periods) increased in the Retention/Rotation
regime—509.8 and 519.80 compared to 408.27 in Panel B—the average ac-
tually declined in the Rotation regime when voluntary dismissals were not
allowed—370.69 compared to 390.75.
A formal test of hypothesis 3a produces mixed results. In the Reten-
tion/Rotation regime the average investment cost of 408.27 in periods when
dismissal was allowed was significantly lower (p < 0.001) than the average
investment cost of 509.8 in the rotation periods of this regime, and the
average investment cost of 519.8 in the retention periods of this regime

(p < 0.001). The average investment cost of 390.75 in the dismissal periods
of the Rotation regime, however, was not significantly different than the
average investment cost of 370.69 in the rotation periods. Finally, contrary
to our prediction, the average investment cost of 376.97 in the retention pe-
riods of the Retention regime was significantly lower (p < 0.001) than the
average investment cost of 596.15 in periods when dismissal was allowed.
We can assess whether the regimes had a spillover effect on investments
by comparing the average investment costs in periods when dismissal was
allowed among the four regimes (Panel B). The highest average investment
cost occurred in the Retention regime, followed by the average investment
costs in the NoRetention/NoRotation, the Retention/Rotation, and finally
the Rotation regimes. This ranking is inconsistent with the prediction based
on an economic perspective. However, the higher average investment costs
in the first two regimes were consistent with our conjecture that the long-
term relationships established in those regimes encouraged higher average
investments. Such relationships could not be formed over the shorter hori-
zons of the two rotation regimes.
6.2 MANAGERS’ DISMISSAL CHOICES

Hypothesis 3a also states that managers would always dismiss auditors who
issue an L̂ report when allowed to do so. Our results do not support this
economic-based prediction. In all regimes, the proportion of dismissals out
of the total opportunities to dismiss was significantly lower than 100%. The
lowest proportion of 27% was observed in the Retention regime, which is
significantly lower than the proportion of dismissals in all other regimes
( p < 0.001). The highest proportion of dismissals, 55%, was observed in
the Retention/Rotation regime ( p < 0.05), whereas the 42% proportion
of dismissals in the NoRetention/NoRotation regime was not significantly
different from the 45% proportion of dismissals in the Rotation regime.
These results also do not support the alternative prediction that managers
would dismiss less (and invest more) in the first two regimes.
6.3 REGRESSION RESULTS FOR MANAGERS’ CHOICES

As with the auditors’ choices, we regress managers’ choices of invest-
ments on other variables which might affect their strategies beyond the
influences of the retention and rotation requirements. We hypothesize that
investment choices, INVESTt , were related to the following variables. In-
vestments will be higher if the manager has previously chosen higher lev-
els of investment, PREV INVESTt . Investments will also be higher if the
manager received a high frequency of unfavorable reports in previous
periods, PREV LOWt . Since investments and dismissals may serve as substi-
tutes, we hypothesize that the coefficient on PREV DISMISS t will be neg-
ative. Finally, we hypothesize that the coefficients on the retention and
rotation dummy variables would be positive. In periods where either is
required, the manager did not have a credible threat of dismissing the
TABLE 7
Regression Results for Managers’ Investment Choices
Neither
Predicted Rotation Rotation and
Sign Nor Retention Retention Rotation Retention
Intercept 0.10∗∗ 0.15∗∗ 0.10∗∗∗ 0.16∗∗∗
( p-Value) (0.04) (0.01) (0.01) (0.00)
PREV− INVEST + 0.83∗∗∗ 0.77∗∗∗ 0.83∗∗∗ 0.69∗∗∗
( p-Value) (0.00) (0.00) (0.00) (0.00)
PREV− LOW + 0.22∗∗∗ 0.10∗∗ 0.05 0.04
( p-Value) (0.00) (0.04) (0.26) (0.29)
PREV− DISMISS − 0.11 −0.09 0.13∗∗ 0.08
( p-Value) (0.19) (0.53) (0.04) (0.50)
D1 + 0.00 0.08∗∗∗
( p-Value) (0.98) (0.00)
D2 + −0.05∗∗∗ 0.07∗∗∗
( p-Value) (0.00) (0.00)
Adj.R2 28.75% 27.64% 29.43% 19.36%
(F -Score) (0.00) (0.00) (0.00) (0.00)
(N) (522) (450) (485) (510)
INVESTt = The investment choice made by the manager at period t.
PREV− INVESTt = The average investment choices made by that manager in periods 1 through t − 1.
PREV− LOWt = The proportion of L̂ reports out of the total reports that the manager received in periods
1 through t − 1.
PREV− DISMISSt = The proportion of dismissal decisions out of the total opportunities to dismiss an
auditor in periods 1 through t − 1.
D 1 = 1 if retention was required at period t and 0 otherwise.
D 2 = 1 if rotation was required at period t and 0 otherwise.
∗∗∗
∗∗
Note. Investment choices by managers at time t are regressed on possible variables that affected managers’
strategies. Specifically,
IN VESTt = β0 + β1 × PREV− IN VESTt + β2 × PREV− LOWt + β3 × PREV− DISMISSt

+ β4 × D 1 + β5 × D 2 + ε.
auditor, so the auditor was expected to have been less likely to issue a fa-
vorable report unless the manager chose a high level of investment which
increases the probability of a HIGH asset. The results are presented in table 7.
We find a positive and significant coefficient on PREV INVEST in all four
regimes, ( p < 0.01), as hypothesized. Hence, managers who chose high lev-
els of investment in previous periods were more likely to invest at a high
level. We also find that managers responded to the previous reports that
were issued by auditors—tending to invest more when they faced a high
frequency of unfavorable reports in the past—but only in the NoReten-
tion/NoRotation regime ( p < 0.01), and the Retention regime ( p < 0.05).
Again, the short horizon imposed by the rotation requirement might not
have allowed for adequate learning and adjusting to auditor reports in the
Rotation regimes. Finally, PREV DISMISS was a significant explanatory vari-
able only in the Rotation regime where managers who dismissed often in the
past also invested more ( p < 0.05). Recall that we hypothesized a negative
coefficient because we assumed that managers would view dismissal and in-
vestment as substitutes. The results, however, do not support this prediction.
7. Conclusions
Repeat audit engagements with clients are believed to provide auditors
with economic rents, either because repeat audits are less costly to perform
or because they offer more opportunities for auditors to supply non-audit
services. However, these expected benefits may provide incentives for au-
ditors to compromise their independence in order to be retained by their
clients. Recently, the SEC proposed new rules of independence, which could
reduce the economic benefits that auditors obtain from the provision of non-
audit services to their clients. AICPA representatives raised strong objections
to these new rules, arguing that “the SEC’s hastily and poorly drafted rule
proposal would wreck havoc on accounting firms of all sizes,” (The CPA
Letter [2000]).
An alternative mechanism for increasing auditor independence that
policymakers have adopted in other countries is to require mandatory ro-
tation of auditors after a number of consecutive engagements. Although
mandatory rotation has been proposed at various times in the U.S., audi-
tors and clients have argued against its adoption because of the excessive
switching costs caused by the regulation and the inability to develop trust-
ing relationships. We are not aware of any empirical study of the relative
costs and benefits of imposing either a mandatory rotation rule or a ban on
non-audit services.13
In the study reported here we used experimental methods to assess the
extent to which mandatory rotation would materially increase auditors’ in-
dependence in comparison to similar regimes in which the requirement
was not imposed on auditor-client relationships. We also included regimes
in which clients had to retain the same auditors for a minimum number of
periods. The minimum requirement is also imposed in several European
countries and, in theory, may improve auditor independence by reducing
the client’s control over the extent to which the auditor will receive eco-
nomic rents.
We observed that the highest frequencies of auditors’ selections of fa-
vorable reports occurred in regimes without mandatory rotation or re-
tention. This result is consistent with the notion that auditors in these
regimes react to economic incentives to bias their reports in favor of man-
agement. But managers also made higher investments than predicted in
these non-retention, non-rotation regimes, thereby raising the probabili-
ties they would have HIGH assets. These higher investments reduced the
overall risk to the auditors of having liability penalties imposed on them.
In effect, the combination of high investments and high favorable reports
increased the welfare of both parties. The latter finding is consistent with
previous experimental research that has shown that players often develop
13
As noted earlier, Dopuch and King [1991] used experimental methods to investigate the
effects of imposing a ban on non-audit services.
tacit cooperation to improve their welfare. Similar cooperative arrange-

ments could not develop in regimes with a rotation requirement because
mandatory rotation truncated repeated interactions between auditors and
managers.
We also compared auditors’ frequencies of favorable reports to the un-
derlying probabilities that the managers had HIGH assets. Average devia-
tions of these frequencies from the underlying probabilities are assumed
to reflect the extent to which auditors biased their reports in favor
of management. We found that the minimum average bias occurred
in the regime with the rotation requirement. In contrast, average positive
biases were observed in the two non-rotation regimes, and an average neg-
ative bias occurred in the regime with both a retention and a rotation re-
quirement. We interpret the latter to reflect a more conservative reporting
strategy of the auditors. The imposition of the two mandatory requirements,
however, resulted in lowest motivation (and opportunity) for auditors and
managers to develop cooperative interactions.
We conclude from our experimental results that mandatory rotation can
increase auditor independence either as a stand-alone rule or in conjunc-
tion with mandatory retention. We should note, however, that our exper-
imental design prevented subjects from interacting in a competitive mar-
ket environment in which competition and reputation could also provide
incentives to managers to make high investments and auditors to report
truthfully. Also, the switching costs imposed by the mandatory require-
ment were kept relatively low in our experiment to provide managers
with the strongest incentives to dismiss auditors who issued L̂ reports.
Finally, we did not investigate the extent to which our results are sensi-
tive to other parameter values chosen for the experiment. For example,
would a lengthening of the retention period reduce the incentives for au-
ditor and manager subjects to adopt cooperative reporting and investment
strategies relative to what we observed in the retention regimes? Alterna-
tively, would an extension of the rotation period increase the incentives
of subjects to adopt these cooperative strategies in the rotation regimes?
These, and perhaps other, limitations suggest future avenues of research
into the relative costs of alternative mechanisms for increasing auditor
independence.
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An Experimental Investigation of Retention and Rotation Requirements

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An Experimental Investigation of Retention and Rotation Requirements

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Journal of Accounting Research

Vol. 39 No. 1 June 2001

Received 11 August 1998; accepted 29 November 2000

We provide results from an experiment designed to assess whether manda-

to compromise their independence. In effect, we design a regime that

2. The Current Debate on Auditor Independence

extent to which the truncation of such benefits through mandatory rotation

3. Experimental Setting, Procedures, and Design

probability q, and a low signal with probability 1 − q.7 We assume an exoge-

3.2 EXPERIMENTAL DESIGN AND PROCEDURES

even if rehired immediately by a new manager. In the second regime the

only at the end of the third period. The experimental design is a 2 × 2 as

No Rotation NoRetention/NoRotation Retention

Rotation after Rotation Retention/Rotation

We conducted three sessions in each of the four regimes, for a total of

Step 1. Each of the six managers is randomly paired with an auditor.

HIGH is 10% (20%, 50%, respectively).11 By informing auditors

4. Strategies and Hypotheses

choice of Ĥ or L̂ is made after observing a low signal and learning the

BiasNoRetention/NoRotation > BiasRetention > BiasRotation

4.2 THE MANAGER’S DISMISSAL AND INVESTMENT STRATEGY

if S < (MH − ML )(1 − αq ). Given the experimental parameters, the setup

a. Economic prediction: Managers use dismissals and investments as

5. Results—Auditors’ Reporting and Independence

Frequency of Ĥ Reports Issued by Auditors After Receiving a low Signal

5.1 FREQUENCIES OF Ĥ REPORTS

to the frequencies in periods in which either mandatory rotation and/or

5.2 BIAS IN AUDITORS’ REPORTING

NoRetention/NoRotation regime (33.03%). We repeat the comparison for

Summarizing, the results consistently show that the rotation requirement

6. Results—Managers’ Investment and Dismissal Choices

6.1 MANAGERS’ INVESTMENT CHOICES

(56/139) instead of 20% before—and fewer choices of the highest invest-

had an average investment cost of 469.54 and dismissed auditors 41/

average investment cost of 519.8 in the retention periods of this regime

6.2 MANAGERS’ DISMISSAL CHOICES

6.3 REGRESSION RESULTS FOR MANAGERS’ CHOICES

IN VESTt = β0 + β1 × PREV− IN VESTt + β2 × PREV− LOWt + β3 × PREV− DISMISSt

tacit cooperation to improve their welfare. Similar cooperative arrange-

AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS. “The Commission on Auditors’

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