Mandatory Audit Firm Turnover, Financial Reporting Quality, and Client Bargaining Power: The Case of Arthur Andersen

This paper examines the effect of mandatory auditor change on audit quality in the unique environment created by the failure of Arthur Andersen (AA). The failure of AA forced a significant number of companies (ex-AA clients) to change auditors and also helped increase the overall skepticism exhibited on external audits. The demise of AA does not truly replicate a mandatory rotation regime, but it does provide a rich setting to examine one aspect of such a regime—the effect that a forced auditor change has on the level of audit quality. Furthermore, because ex-AA clients were forced to change auditors on a one-time basis and will not necessarily have to change auditors in the future, client bargaining power is likely to influence auditor behavior and is considered in this study's empirical analyses. This study provides evidence that, for smaller companies, the level of audit quality improved for companies forced to switch from AA, and that the negative relation between short auditor tenure and audit quality was effectively mitigated over the period of AA's demise. The lack of results for larger companies could reflect higher bargaining power toward their auditor. Further research is needed to determine if a forced auditor change would improve audit quality for larger companies in a true mandatory auditor rotation regime, where the amount of bargaining power possessed by companies would seemingly diminish.