The Effect of Mandatory Auditor Rotation on the Cost of Capital and Credit Ratings: Evidence from Periodic Auditor Designation (PAD) Policy in South Korea

This paper investigates the effect of mandatory auditor rotation, as implemented by the Periodic Auditor Designation (‘PAD’ hereafter) policy, on the cost of capital and credit ratings. By analyzing hand-collected data on PAD policy, which was introduced through the revision of the ‘Act on External Audit of Stock Companies and Other Related Laws’ in South Korea, I find two notable findings. First, the results show that the weighted average cost of capital for firms subject to the PAD policy is lower compared to those firms are not subject to it, consistent with the prediction. Second, the implementation of mandatory auditor rotation through the PAD policy is positively associated with the credit ratings of client firms. To further strengthen the validity of main findings, I conduct a robustness test and find that the main findings are robust even after controlling the potential effects of other audit-related rules implemented by the Act on External Audit of Stock Companies and Other Related Laws. Furthermore, I conduct an additional test to thoroughly investigate the incremental impacts of audit hours and fees. The results reveal that as audit hours and fees increase, the relationship between PAD and cost of capital (as well as credit ratings) becomes less prominent. Overall, this study makes contributions to the existing body of research and provide practical implications, highlighting the significant role of mandatory auditor rotation implemented through the Periodic Auditor Designation in influencing the cost of capital and credit ratings.