Strong Corporate Governance and Audit Firm Rotation: Effects on Judges' Independence Perceptions and Litigation Judgments

Abstract

The Sarbanes-Oxley (SOX) legislation mandated modest threshold levels of corporate board independence and expertise, as well as audit partner (not firm) rotation. One objective was to create an environment supportive of enhanced actual and perceived auditor independence. This study examines whether perceptions of auditor independence and auditor liability are incrementally influenced by further strengthening corporate governance and by rotating audit firms. Our experimental study addresses these questions by analyzing responses of 49 judges attending a continuing education course at the National Judicial College. The experiment manipulates corporate governance at two levels (minimally compliant with current corporate governance requirements versus strong) and auditor rotation at two levels (partner rotation versus audit firm rotation). We find that strengthening corporate governance (beyond minimal SOX levels) and rotating audit firms (compared to partner rotation) lead to enhanced auditor independence perceptions. We also find that judges consider auditors less likely to be liable for fraudulently misstated financial statements when firm rotation is involved in a minimally compliant corporate governance environment.