chi - 2011 - an overlooked effect of mandatory audit–firm rotation on investigation strategies [mafr]

by focusing on the economic costs of mandatory audit–firm rotation while taking intoaccount the enhanced role of an independent board or an independent audit com-mittee, which is require

Keywords Sarbanes–Oxley Act· Audit–firm rotation · Audit fees ·

Investigation strategy

1 Introduction

Recent scandals involving accounting irregularities have damaged the credibility ofaccounting audits In an attempt to help restore this lost credibility, the US Congresspassed the Sarbanes–Oxley Act of 2002 (hereafter the SOX Act) Section 203 of thisact mandates audit–partner rotation, and section 207 requires a study of mandatory

W Chi (B)

National Chengchi University, 64, Zhi-nan Road, Section 2,

Wenshan, 11623 Taipei, Taiwan, Republic of China

e-mail: wchi@nccu.edu.tw

rotation of registered public accounting firms.1This research aims to contribute tosuch study by uncovering and examining an overlooked cost of mandatory audit–firmrotation.

Such an examination, if properly conducted, cannot focus solely on section 207 ofthe act It must also consider other requirements imposed by this legislation, includinghigher standards for the makeup and role of the independent audit committee (section301) Such joint requirements complicate the analysis of any effects of mandatoryrotation, for they mandate additional changes to which those effects might also beattributed Of particular note when considering section 301 is the possibility that man-datory rotation actually hamstrings the board by preventing it from rewarding goodaudits by retaining a well-performing auditing firm.2

Another complication of this study is the lack of relevant data Because few tries have put such mandatory rotation into practice, there is little empirical evidenceavailable for analysis of its costs and benefits My research, therefore, uses an analyt-ical approach to examine the economic costs of mandatory rotation in a setting thatalso includes an independent audit board or committee

coun-The traditional view of auditor rotation involves a tradeoff between the benefits anddrawbacks of familiarity This paper does not enter this debate, but rather provides ananalysis of certain drawbacks that have gone unnoticed but should be considered infuture debates on auditor rotation One side of the traditional view of rotation holds thatfamiliarity with clients is crucial to produce greater understanding and an improvedability to identify and evaluate risks for clients and that rotation limits an auditor’sability to develop such an understanding and ability On the other hand, some auditingprofessionals also recognize that over-familiarity may be a significant threat to audi-tor independence The potential impairment of auditor independence constitutes thebasic reason for requiring audit–partner and/or audit–firm rotation In addition, newauditors, an inevitable consequence of auditor rotation, may provide a fresh, unjadedview of the firm during the audit process

The SOX Act reflects these traditional views Specifically, section 203 of the SOXAct treats audit services as unlawful if the lead or the coordinating audit partnerprovides services for five consecutive years to a certain client In addition, section

207 of the SOX Act requires the Comptroller General to conduct a study to ine the potential effects of the mandatory rotation requirement on registered publicaccounting firms within one year of the passage of the SOX Act One can say thatsection 207 suggests that mandatory audit–firm rotation may be an effective means

exam-of restoring the credibility exam-of the audit function This paper examines this suggestion

1 In general, there are two types of auditor rotation: audit–partner rotation and audit–firm rotation Since the SOX Act has already enforced audit–partner rotation in section 203 but merely calls for the study of audit–firm rotation, this paper focuses on audit–firm rotation For simplicity, in this article, “mandatory rota- tion” refers to audit–firm rotation rather than to audit–partner rotation Following the requirements of SOX

207, the Government Accountability Office (formerly the Government Accounting Office) is responsible for studying the effectiveness and implications of audit firm rotation.

2 The idea of mandatory auditor rotation existed prior to recent reforms In fact, the Report of the

Commission on Auditors’ Responsibilities (The Cohen Commission) ( 1978 ) recommended mandatory rotation The Cohen Report reasons that “[s]ince the tenure of the independent auditor would be limited, the auditor’s incentive for resisting pressure from management would be increased” (p 108).

by focusing on the economic costs of mandatory audit–firm rotation while taking intoaccount the enhanced role of an independent board (or an independent audit com-mittee), which is required by section 301 of the SOX Act, which addresses boardeffectiveness.

Stressing the idea that the audit committee plays an active role in corporate ernance and acknowledging that there exists a potential for side payments to audi-tors from managers (Lee and Gu 1998),3I analytically examine the effectiveness ofimplementing mandatory audit–firm rotation Although conventional wisdom sug-gests that requiring mandatory rotation will enhance auditor independence, this studysuggests that the mandatory audit–firm rotation requirement is likely to make theaudit committee adopt a more aggressive investigation strategy to examine the possi-bility of collusion between the manager and the auditor as well as pay a higher auditfee Therefore, the mandatory audit–firm rotation requirement creates a cost burden

gov-to the firm, namely an extra audit fee payment and a higher monigov-toring cost due

to a more aggressive anti-collusion strategy The conclusion of this study runs trary to the conventional perspective that treats the mandatory rotation requirement

con-as a means to enhance audit effectiveness and, in turn, improve the quality of cial reporting This conventional perspective ignores the existence of an independentaudit committee that is mandated by section 301 Such an independent audit com-mittee represents the interests of shareholders and helps ensure the objectivity of theaudit process by decreasing the possibility of collusion between management andauditor—the very possibility that auditor rotation is supposed to guard against Such afunctional redundancy would not necessarily be a drawback of auditor rotation, but infact this rotation does have a cost: the elimination of an incentive to the auditor Theboard can no longer reward good performance—which would include the avoidance

finan-of collusion with management—by continuing to hire the auditor, so the incentive forsuch collusion is actually increased By failing to consider the role of the board (oraudit committee) in providing incentive and reducing collusion, prior literature hasassumed that auditor rotation can only increase auditor independence, not decrease it.When we consider the possibility of such a drop in auditor independence, however,

3 Although manager–auditor side payments were generally prohibited even before the SOX Act, Lee and

Gu ( 1998) indicate that side payments could take several forms, some of which were prima facie legal (e.g.,

the auditor might be appointed by the manager on behalf of the shareholders and the manager could use the appointment itself as a side payment to sway the auditor) and some of which might be legally justified (e.g., granting the auditor with consulting contracts) Generally, preventing or detecting side payments can

be legally difficult and expensive See Footnote 5 (p 536) of Lee and Gu ( 1998 ) for a detailed discussion

of potential side payments between the manager and the auditor The SOX Act of 2002 has added more restrictions on such side payments, prohibiting, for example, most types of consulting and the hiring of former auditors by the audited firms within a year of the audit( United States Code 2002 ) A public account- ing firm can, however, still perform non-auditing services, such as tax services Some recent studies provide circumstantial evidence that tax services can be a channel for side payments Dhaliwa et al ( 2004 ), for example, find that changes in effective tax rates (ETR) between the third and fourth quarters are related

to efforts toward earnings management Omer et al ( 2006 ) further find that one-year-ahead marginal tax rate and ETR reductions are associated with higher tax-service fees paid to the audit firms Although this evidence is not definitive, it suggests that, despite the provisions of the SOX Act, there may exist channels for managers to deliver side payments to auditors.

the costs of auditor rotation in the context of an independent audit committee becomeclear.

The remainder of the paper is organized as follows Section2reviews the debate

on auditor independence, tenure, and mandatory rotation Section3describes the auditpricing model and the investigation strategy of the audit committee innon-rotation-required and rotation-required environments Section4 discusses thesolution and explains the economic consequences of mandatory rotation I presentconcluding remarks in Sect.5

2 The debate

Since independence is the cornerstone of the auditing function, both legislators andfinancial statement users are highly concerned with this issue To reduce the potentialthreat to auditor independence, proponents of mandatory rotation express the beliefthat poor quality of financial statements is associated with extended auditor tenure Forexample, in July 2003, the International Federation of Accountants (IFAC) issued a

report, Rebuilding Public Confidence in Financial Reporting, in which it treats

exces-sive familiarity as potentially resulting in auditors’ complacency or hesitancy to lenge appropriately, thereby reducing the level of skepticism necessary for an effectiveaudit (International Federation of Accountants (IFAC) 2003).Louwers(1998) foundthat the length of the auditor–client relationship affects auditors’ propensity to issue

chal-a going-concern disclosure to chal-a distressed client Hence, proponents of rotchal-ation gest that it could significantly improve the overall quality of an audit and enhance thequality of the financial reporting process (e.g.,Imhoff 2003;Dopuch et al 2001).However, the existence of a well-functioning independent board (or an indepen-dent audit committee), such as required by section 301 of the SOX Act, may renderthose arguments invalid The independent board or audit committee represents theinterests of shareholders, particularly by ensuring the objectivity of the audit process

sug-International Federation of Accountants (IFAC) (2003) also believes that the auditcommittee needs to interact directly and, at times, forcefully with both managementand auditors in areas that in the past have been largely handled outside the commit-tee.4In prior literature, discussions on the function of audit committees (e.g.,Booth

et al 2002;Klein 2002) and the effectiveness of mandatory rotation (e.g.,Arrunadaand Paz-Ares 1997;Catanach and Walker 1999;Dopuch et al 2001) have generallybeen treated as independent issues However, the effectiveness of mandatory rotation

in improving the quality of financial statements is directly influenced by the tion of the audit committee, since this committee is closely involved in the process

func-of preparing these financial statements Therefore, it is important to include the role

4 The report recommends that each member of an audit committee should be financially literate, and at least one (and preferably a majority) of the committee’s members should have substantial financial expe- rience The report also recommends that everyone on the audit committee (members and non-members of management alike) should receive training both with respect to their general responsibilities and regarding the operations, business issues, financial reporting, control systems, and risk management processes of the company itself.

of an effective audit committee in discussing the merits of the mandatory rotationrequirement.5

In a situation where section 301 of the SOX Act is actually enforced, I assume thatthe possibility that management might threaten the audit firm is eliminated That is,this paper analyzes the result of a theoretical effectiveness of section 301 of the SOXAct and assumes that the concerns over enforcement expressed in the past literature,such as those over managers’ improper influence on auditors due to auditors’ fear

of losing clients due to disagreement with managers’ financial reporting preferences(e.g.,Farmer et al 1987).6Cautious optimism about the effective enforcement of Sec-tion 301 is justified by recently issued auditing standards that require communicationbetween auditors and audit committees about unrecorded misstatements (SAS No

89,American Institute of Certified Public Accountants (AICPA) 1999a) and the tor’s judgment about the quality, not just the acceptability, of accounting principlesand underlying estimates in the financial statements (SAS No 90,American Institute

audi-of Certified Public Accountants (AICPA) 1999b) Those requirements enhance theimportance of the audit committee, giving it a critical role that dominates the role

of managers in affecting the outcome of accounting negotiations with the client Insummary, auditor rotation becomes less pivotal in a situation where there exists a wellfunctioning independent board (or independent audit committee) as required by theSOX Act than in a pre-SOX Act environment where auditors can never be completelyindependent.7

Opponents of mandatory rotation assert that auditors have to gain experience andbuild client-specific assets from the ongoing relationship in order to develop a greaterability to detect accounting irregularities (Arrunada and Paz-Ares 1997).Geiger andRaghunandan(2002) have also demonstrated that there are significantly more auditfailures in the earlier years of the auditor–client relationship Some recent empiricalstudies have investigated the relationship between auditor tenure and discretionaryaccruals and found that short audit tenure leads to lower audit quality (e.g.,Johnson

et al 2002;Myers et al 2003;Ghosh and Moon 2005;Chen et al 2008).8The dence shows that the mandatory rotation requirement decreases audit effectiveness

evi-5 Members of the board that are independent of management are likely to be more effective in overseeing management than those that are not This study assumes that there exists a well-functioning independent board or audit committee in the firm.

6 See Bazerman et al ( 1997 ) for a general discussion of the challenges faced by auditors when they know that the client “ may hire and fire auditors at will” (p 91).

7 This idea is echoed in the following paragraph from the General Accounting Office required study on the potential effects of mandatory audit firm rotation on public accounting firms ( US Government Accounting Office 2003 ): “We also believe that if audit committees regularly evaluated whether audit firm rotation would

be beneficial, given the facts and circumstances of their companies’ situation, and are actively involved in helping to ensure auditor independence and audit quality, many of the benefits of audit firm rotation could

be realized at the initiative of the audit committees rather than through a mandatory rotation requirement” (p 9).

8 This approach treats audit quality as a function of earnings quality, which is measured by discretionary accruals Other proxies for earnings quality include restatements ( Stanley and DeZoort 2007 , and fraudulent financial reporting ( Carcello and Nagy 2004 ) In addition, studies investigating the relation between audit firm tenure and perceptions of earnings quality include Mansi et al ( 2004 ), who use the cost of debt financ- ing to proxy for creditor perceptions, and Ghosh and Moon ( 2005 ), who use earnings response coefficients

and thus lowers the quality of financial reporting In addition, the National mission on Fraudulent Financial Reporting (The Treadway Commission)(1987) hasrecommended that the peer review program of the AICPA’s SEC Practice Section paycloser attention to the first-year audits of public clients This recommendation wasmade partly because the Commission’s review of fraud-related cases revealed that

Com-a significCom-ant number of those cCom-ases involved compCom-anies thCom-at hCom-ad recently chCom-angedauditors (p 54) Further, the Quality Control Inquiry Committee of the AICPA’s SECPractice Section found that audit failure occurs almost three times as often on first- orsecond-year audits (American Institute of Certified Public Accountants(AICPA) 1992)

In summary, these investigations suggest that mandatory rotation could diminish auditeffectiveness and thus lower the quality of financial reporting

In spite of the existing empirical evidence, there are at least two reasons to examinethe issue via the analytical approach First, the results of the empirical studies (e.g

Johnson et al 2002;Myers et al 2003;Ghosh and Moon 2005;Chen et al 2008) werefound in a legal environment that did not require audit firm rotation An analyticalanalysis can provide supplemental arguments and another perspective to complementprior empirical evidence Second, audit quality is determined by separate factors: theauditor’s ability to discover errors or breaches, and the degree of independence required

to report the errors truthfully (DeAngelo 1981) All existing empirical evidence,

how-ever, is based on a joint test of auditors’ independence and ability To address how

mandatory rotation affects auditor independence and audit pricing, I assume that auditeffort is unchanged either in a rotation-required or non-rotation-required environment

In the next section, I simplify the model ofLee and Gu(1998) to examine the costsassociated with mandatory auditor rotation, particularly monitoring costs and auditfee payments The focus of theLee and Gu(1998) study is to examine the relationshipbetween low-balling and auditor independence They analyze the interaction amongthe firm owner, the manager, and the auditor, and conclude that low-balling consti-tutes an efficient dynamic contracting mechanism for hierarchal agency Specifically,they find that low-balling creates a disincentive for unscrupulous audit behavior whenthe right to hire and fire the auditor lies with the owner The present paper uses thesame framework to analyze the difference in the optimal investigation strategies underrotation-required and non-rotation-required environments where the right to hire andfire the auditor lies in an independent board (or an independent audit committee)

3 The investigation strategies

To examine how mandatory rotation affects audit pricing and auditor independence,

I analyze the audit fee payments and optimal investigation strategies of the auditcommittee in non-rotation-required and rotation-required environments, respectively.Because of its focus on the role of the auditor, this paper does not examine alternative

footnote 8 continued

to proxy for investor perceptions Regarding the effect of mandatory rotation on audit quality, Chi et al.

( 2009 ), using evidence from Taiwan, find no evidence that mandatory audit–partner rotation has positive effects on audit quality Likewise, Ruiz-Barbadillo et al ( 2009 ), using evidence from Spain, come to similar conclusions regarding mandatory audit–firm rotation.

strategies to induce truthful reporting, such as a contract between the audit committeeand the manager, for such a strategy eliminates consideration of the auditor.

3.1 The optimal investigation strategy in a non-rotation-required environment

I assume that the audit market is price competitive and that the client’s switching costsand auditor’s start-up costs are non-zero Following the model fromDeAngelo(1981),

I calculate the audit fee in a non-rotation-required environment (denoted by N R) Let

F1;N R represent the audit pricing in the initial engagement, and F n ;N R = F N R (for

n ≥ 2), the audit fee for subsequent periods Further, there is a constant component

to audit cost in each period, A n = A (for n ≥ 2), and a start-up cost, K , in the initial period so that A1 = A + K represents the initial audit A client who switches his or her auditor incurs a transaction cost, denoted by S Finally, r is the discount rate that

applies to the auditor’s future profits

Fact 1: In a non-rotation environment:

1 The audit fee on the initial engagement is F∗

Proof SeeDeAngelo(1981) or the brief outline in Appendix1

Assuming that a firm has a well-functioning audit committee that has the sibility to hire and fire the auditor, I employ the following monitoring and incentivestructure, similar to the one used in theLee and Gu(1998) Particularly, the boardemploys a manager to handle production and an auditor to verify the reported infor-

respon-mation However, the auditor might accept a side payment B to report with bias in

favor of the manager.9Because a pure strategy of constantly monitoring an expert and,therefore, relatively efficient auditor removes the advantage of hiring such an auditor,

it is too costly for the board to adopt such a pure strategy to always investigate whetherthere exists collusion between the auditor and the manager For the same reason, apure strategy never to investigate is not beneficial for the board either

Accordingly, I assume the board chooses a mixed strategy to scrutinize the sion, with probabilityπ1;N Rin the first period of auditing, andπ N Rin each subsequentperiod Furthermore, if the board investigates and the two agents (i.e., the manager and

collu-the auditor) have colluded, collu-the board will discover collu-the misconduct with probability p

(where 0< p < 1) When the two agents behave loyally, there is no evidence that

can suggest an allegation of malpractice by the two agents, whether the boards tigates or not Finally, when the collusion is revealed at a certain time, the auditor pays

inves-a one-time leginves-al punishment D inves-and his future income is norminves-alized to zero.10In otherwords, the entire calculation of profit from collusion includes three parts: the periodsbefore collusion is detected, during each of which some profit should be expected; the

9 To focus on the issue of mandatory rotation, I treat the side payment B exogenously for tractability.

10 To examine how mandatory rotation affects the auditor’s independence, I omit the penalty on the manager.

period when collusion is detected, which will result in a penalty; and the periods aftercollusion has been detected, during which the profit from collusion will be zero.

I will start by describing the auditor’s strategy—a pure strategy either of dence or collusion—in the non-initial period If the auditor does not collude with themanager, the present value of his total profits is:

indepen-(F N R − A)(1 + r)

However, when he colludes with the manager, the auditor receives a payoff B+

F N R − A with probability (1 − π N R ) + π N R (1 − p), since the board could either not

investigate (with probability 1− π N R) or investigate (with probabilityπ N R) but notdiscover the misconduct (with probability 1− p) When the board discovers the collu- sion of the two agents, the auditor pays the fixed court-determined penalty D.11Sincethe auditor has the same optimization problem in each non-initial period, if an auditor’sbest choice is to collude in a given period, it is implied that collusion will constitute thebest strategy in each subsequent period as well Consequently, the expected presentvalue of the auditor’s profits from the collusion strategy in a non-initial auditing periodis:

11 For simplicity, this paper follows Lee and Gu ( 1998 ), which treats the court-determined damages as fixed That is, I omit the potential effect of audit liability regimes ( Hillegeist 1999 ), materiality uncertainty ( Patterson and Smith 2003 ), and inconclusive evidence of fraud ( Patterson and Wright 2003 ) This paper assumes that the auditor cannot receive the net profit, including side payments, of the engagement auditor

(B + F N R − A) if he colludes and is discovered This assumption can simplify the proof, although the

major conclusion of this study will be unchanged if D excludes the incurred A, regardless of collusion or its

detection In addition, one may argue that it should include the “fresh view effect” of the successor auditor into the model In fact, to assess how audit–firm tenure affects audit quality, Myers et al ( 2003 ) examined the relationship between abnormal accruals and audit–firm tenure They found no evidence that a lengthy audit–firm tenure has a negative effect on audit quality In fact, their results show that audit–firm tenure enhances, rather than decreases, audit quality, which implies that short audit tenure leads to lower earnings quality because auditing expertise, accumulated by tenure, is important for auditors to detect accounting irregularities Thus, this paper does not assume any “positive” or “negative” role of the new successor auditor, who might have less client-specific expertise than the predecessor auditor.

Y denote the result of Eq (2) subtracted from Eq (1), we have:

Y Taking the partial derivative of Eq (3) with respect to F N R − A and B yields:

The results show that Y is increasing with the normal audit profit (F N R − A), and

decreasing with the level of the side payment Therefore, either a lower normal ment profit earned by the auditor or a higher side payment afforded by the manager, willinduce collusion and threaten auditor independence Because investigation is costly,the board will choose the lowestπ R for which Y is equal to zero.12 After a simplearrangement,π∗

engage-N Rsatisfies the following condition:

a competitive audit market, the profit of an auditor with independence is zero

How-ever, if the auditor compromises his independence then he earns an extra B in period

1 (with probability 1− π1 ;N R · p) or pays punishment D if collusion is detected by

the board (with probabilityπ1;N R · p) Using Eq (7), which assumes zero profit in

12 In other words, I assume that an auditor who is indifferent between independence and collusion will choose to remain independent.

audit markets, and the backward induction approach, I arrive at the net expected value

of profits from the collusion strategy(1 − π1;N R · p)B − π1 ;N R · (pD).13Further, theoptimal randomized investigation of the board in the initial period,π∗

Proposition 1 For an environment without mandatory rotation:

Proposition 1expresses the investigation strategies of the independent audit

com-mittee in a non-rotation environment in each period in terms of side payments (B), penalties to the auditor for collusion with the manager (D), and the probability of discovery of misconduct ( p); for periods after the initial one, the auditor’s set-up costs (K ) and the client’s switching costs (S) are added.

3.2 The optimal investigation strategy in a rotation-required environment

To analyze how mandatory rotation affects the board’s investigation strategy in eachperiod, I useπ n ;R (N) to represent the mixed strategy in period n (1 ≤ n ≤ N), where

13 Ideally, this formula should be expressed as(1− p ·π1;N R )· (B+ Present Value of an Audit Engagement

in an Initial Year) −π1;N R · (pD) However, assuming a zero-profit audit market, the term Present Value

of an Audit Engagement in an Initial Year, reduces to zero.

14 The fact that the fee in the initial period is lower than in subsequent periods is what is commonly referred

to as “low-balling” or “low introductory pricing.” As compared to legal enforcement and investigation egy, Lee and Gu ( 1998 ) explain that low-balling itself is an economical mechanism to self-fulfilled auditor independence In Sect 3.2, I will show that mandatory rotation interferes with this mechanism.