bergner - 2011 - auditor rotation and auditor independence - an investigation using social identity theory and accountability

LIST OF TABLES Table 2.1 - Countries undercurrent Mandatory Firm Rotation 21 Table 4.1 - Manipulation Check Results for Pilot Study 70 Table 4.2 - Results of Confirmatory Factor Analysis

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DISSERTATION

Jason Marlin Bergner

The Graduate School University of Kentucky

2011

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AUDITOR ROTATION AND AUDITOR INDEPENDENCE:

AN INVESTIGATION USING SOCIAL IDENTITY THEORY AND

ACCOUNTABILITY

DISSERTATION

A dissertation submitted in partial fulfillment of

requirements for the degree of Doctor of Philosophy in the

College of Business and Economics

at the University of Kentucky

By Jason Marlin Bergner Lexington, Kentucky Director: Dr Robert Ramsay, Professor of Accounting

Lexington, Kentucky

2011

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UMI Number: 3501618

In the unlikely event that the author did not send a complete manuscript and there are missing pages, these will be noted Also, if material had to be removed,

a note will indicate the deletion

UMI

Dissertation Publishing

unauthorized copying under Title 17, United States Code

uest

ProQuest LLC

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P.O Box 1346 Ann Arbor, Ml 48106-1346

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ABSTRACT OF DISSERTATION

ACCOUNTABILITY

The AICPA and GAO claim that audit partner rotation provides

substantially the same benefits (independence) as audit firm rotation

Meanwhile, the PCAOB has solicited comments on a potential regulation requiring the lead engagement partner's personal signature to appear on the publicly disclosed audit report In this experiment-based dissertation, I use Social Identity Theory to make predictions regarding auditors' independence levels in partner and firm rotation scenarios I also investigate accountability's effect on auditors' decisions, including how accountability interacts with

identification The results suggest identification interacts with accountability in affecting auditors' decision making and that auditors may make different

decisions under partner and firm rotation These results are informative to the PCAOB and practitioners in discussing the current issues of firm rotation and partner signing

KEYWORDS: audit partner rotation, auditor independence, mandatory rotation,

accountability, Social Identity Theory

Student's signature

Date

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The Graduate School University of Kentucky

2011

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ACCOUNTABILITY

A dissertation submitted in partial fulfillment of

requirements for the degree of Doctor of Philosophy in the

College of Business and Economics

at the University of Kentucky

By Jason Marlin Bergner Lexington, Kentucky Director: Dr Robert Ramsay, Professor of Accounting

Lexington, Kentucky

2011

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ACCOUNTABILITY

The AICPA and GAO claim that audit partner rotation provides

substantially the same benefits (independence) as audit firm rotation

Meanwhile, the PCAOB has solicited comments on a potential regulation requiring the lead engagement partner's personal signature to appear on the publicly disclosed audit report In this experiment-based dissertation, I use Social Identity Theory to make predictions regarding auditors' independence levels in partner and firm rotation scenarios I also investigate accountability's effect on auditors' decisions, including how accountability interacts with

identification The results suggest identification interacts with accountability in affecting auditors' decision making and that auditors may make different

decisions under partner and firm rotation These results are informative to the PCAOB and practitioners in discussing the current issues of firm rotation and partner signing

KEYWORDS: audit partner rotation, auditor independence, mandatory rotation,

accountability, Social Identity Theory

S|ude,nt's signatu

Date

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ACCOUNTABILITY

By

Director bT-Gc&duate Studies

Date

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ACKNOWLEDGEMENTS

I wish to express sincere gratitude to the University of the Kentucky, the

UK Graduate School, the Gatton College of Business and Economics, and the Von Allmen School of Accountancy for their continued financial support

The following dissertation, while an individual work, has benefited greatly from the insights and direction of several people First, my Dissertation Chair,

Dr Robert Ramsay, exemplifies the high quality scholarship to which I aspire Our meetings and his comments proved invaluable during this process I also wish to thank the rest of the Dissertation Committee for their helpfulness,

critiques, and time in helping me to achieve this goal: Dr Jeff Payne, Dr Sean Peffer, and Dr Richard Smith

I also wish to thank those outside the Committee whose comments and constructive criticisms were especially helpful: Hank Alewine, Bill Messier, Tim Miller, Dan Stone, and Steve Sutton I apologize to anyone whom I have

inadvertently left off this list All remaining errors within are mine alone

Finally, I wish to thank my family, my wife Jody and our children Their support and encouragement brightened the darkest periods of this entire

educational process and gave me the incentive to work as hard as I could each day

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TABLE OF CONTENTS Acknowledgements iii

List of Tables vi List of Figures vii Chapter 1: Introduction 1

Objective 1 Motivation 3 Contribution 7 Organization 8 Chapter 2: Literature review 9

Organization 9 Auditor independence 10

Constraints inhibiting auditor independence 11

Incentives encouraging auditor independence 13

Auditor rotation and independence 15

Audit firm and partner rotation 16

Introduction 16

Audit firm rotation 17

Archival partner rotation 26

Audit firm v audit partner rotation 28

Summary 30 Social Identity Theory 32

General 32 Organizational commitment 34

Organizational identification 35

Client identification 36

Professional identification 38

Accountability 40 Accountability and identification 42

Chapter 3: Hypotheses development and research design 45

Independent variables * 61

Other variables 63

Materials and procedures 64

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Appendix A - Online version of instrument 103

Appendix B - Paper and pencil version of instrument 145

References 176

VITA 184

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LIST OF TABLES

Table 2.1 - Countries undercurrent Mandatory Firm Rotation 21

Table 4.1 - Manipulation Check Results for Pilot Study 70

Table 4.2 - Results of Confirmatory Factor Analysis 72

Table 4.3 - Effect of Rotation Type and Accountability on Auditors' Client

Id entifi cation 74 Table 4.4 - Effect of Client Identification and Accountability on Auditors'

Independence 76 Table 4.5 - Effect of Rotation Type and Accountability on Auditors'

Independence 77 Table 4.6 - Effect of Client ID and Accountability on Auditors' Independence,

Gender Covariate Included 81

Table 4.7 - Demographic Information for Auditor Sample 84

Table 4.8 - Manipulation Check Results for Auditor Study 85

Table 4.9 - Results of Confirmatory Factor Analysis 86

Table 4.10 - Effect of Rotation Type and Accountability on Auditors' Client

Identification 89 Table 4.11 - Effect of Client Identification and Accountability on Auditors'

Independence 91 Table 4.12 - Effect of Rotation Type and Accountability on Auditors'

Independence 92 Table 4.13 - Effect of Rotation Type and Accountability on Auditors' Client

Identification, partner and senior manager subsample 94

Table 4.14 - Effect of Client Identification and Accountability on Auditors'

Independence, partner and senior manager subsample 96

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LIST OF FIGURES

Figure 3.1 - Dissertation Model 51

Figure 4.1 - Effects of Client Identification and Accountability on Warranty

Adjustment 79 Figure 4.2 - Effect of Rotation Type and Accountability on Auditors' Client

Identification, partner and senior manager subsample 95

Figure 4.3 - Effects of Rotation Type and Accountability on Likelihood of

Requiring Client to Restate Prior Year's Earnings, partner and senior

manager subsample 97

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Chapter 1: Introduction

Objective

This dissertation investigates auditor independence under two different scenarios: partner rotation and firm rotation1 The General Accounting Office (2003) and the American Institute of Certified Public Accountants (1992) both claim that the current U.S requirement of mandatory partner rotation has

substantially the same benefits (read: independence) as mandatory firm rotation, rendering mandatory firm rotation unnecessary I investigate this claim and investigate if auditors are equally independent under partner and firm rotation scenarios

I also investigate how accountability may a) mitigate the potential

differences in auditors' independence levels and b) interact with auditors' client identification Although many facets of accountability exist in the current audit environment (concurring partner review, Audit Committee, etc.), I examine

accountability using an issue currently under discussion by the Public Company Accounting Oversight Board (PCAOB); namely, the proposed requirement for the lead audit partner to sign his/her name to the publicly disclosed audit report.2

I develop a model of auditor rotation and test this model using an

experiment to explore audit partners' independence based upon the type of

"new" client (rotating in from another partner within the firm versus rotating in

1 In an auditing context, "rotation" refers to the idea of limiting the number of consecutive years an auditor can audit a client In "partner rotation," the lead engagement partner must pass that responsibility to another partner in the firm after a fixed number of years In "firm rotation," the audit firm itself must withdraw from the engagement (thus forcing the client to seek a new audit firm) after a fixed number of years

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from a different firm) coming under the partner's purview and the potential effect

of signing one's name to the publicly disclosed audit report on partners'

independence levels In the first part of the model, I test whether auditors under

a firm rotation scenario will identify (Social Identity Theory) with their clients differently than those under partner rotation In other words, I test whether

rotation type is an antecedent of identification Bamber and Iyer (2007) find that three constructs are antecedents of identification: auditors' individual tenure with the client, client "importance," and client "image." Antecedents to identification are important because research shows that auditors make different decisions based upon their identification levels with clients (Bamber and Iyer 2007) Thus,

if rotation type is an antecedent to identification, it should follow that auditors' decision making will be different under firm v partner rotation

In the second part of the model, I investigate how auditors' identification levels with the client and accountability affects their decision making As

mentioned earlier, previous research (Bamber and Iyer 2007) shows that

auditors' identification levels affect their decision making However, no research has studied whether a) accountability measures will mitigate any differences in identification and b) whether accountability and identification interact Though the interaction between accountability and identification has not been studied in the auditing literature, it has been shown in the psychology literature (Baretto and Ellemers 2000, Smith et al 2007) In some psychological studies, accountability has been shown to interact with identification by affecting those who are "high" identifiers (Reicher and Levine 1994) In other studies, it is the "low" identifiers

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who are affected by accountability (Baretto and Ellemers 2000) Therefore, a priori, it is unclear how auditors' identification with clients may be affected by accountability

In this dissertation, I assume that auditors' independence levels are

revealed by their decision making Therefore, I am able to measure auditors' independence levels directly Unlike many archival studies that indirectly

measure auditor independence with proxies such as earnings quality, I directly measure auditor independence, using auditors' decisions about requiring the posting of an adjusting entry, the amount to insist on being posted as an

adjusting entry, whether to give a going concern opinion, and whether to insist on

a restatement of the previous year's financial statements

This experimentally-based dissertation seeks to provide direct evidence

on auditors' independence levels in partner versus firm rotation settings as well

as the effect of requiring lead audit partners to sign the audit report Standard setters have looked at these issues in the past (e.g., GAO 2003) and continue to

do so today (PCAOB 2009) I strive to provide a priori evidence on the potential

consequences of implementing these standards

Motivation

Previous researchers, both archival and experimental, have tested the potential effects of requiring mandatory firm rotation However, these studies have examined firm rotation versus no rotation (Dopuch et al 2001) or have investigated how audit firm tenure is related to audit quality, often using earnings

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quality proxies as proxies for audit quality (e.g., Myers et al 2003) In the former case, effects of firm rotation versus non rotation can be directly measured, but the omission of the partner rotation variable makes these studies unable to

answer the claim of equality of benefits in partner and firm rotation settings In the latter case, firm rotation is not manipulated Associations between short and/or long tenure and earnings quality (for instance) are examined to see if firm rotation is warranted Neither do these studies address the question of firm versus partner rotation

A few archival-based studies have investigated firm and partner tenure settings, made possible by the fact that some countries require the lead audit partner to sign the publicly disclosed audit report (e.g., Taiwan) Research here has yielded mixed results, with some supporting firm rotation (Chi and Huang 2005) and some against (Knechel et al 2007) However, these studies cite the limitation of these results generalizing to cultures and markets outside of their specific locales, as well as the limitations of using proxies to measure audit

quality Chi et al (2009) state their inferences "critically depend" on the ability of accrual-based proxies to capture audit quality, proxies that are called into

question by Bamber and Bamber (2009).3 Additionally, earnings opacity

(Bhattacharaya et al 2003), accounting and auditing practice in corporate

3 Bamber and Bamber (2009) question common proxies used to capture audit quality, such as abnormal accruals Proxies like abnormal accruals are commonly used to measure earnings quality in the financial accounting literature The logic then proceeds that companies with higher earnings quality also have high-quality audits However, this does not necessarily hold A company with high quality earnings via strong internal controls and thorough, honest

management would publish financial statements with high quality earnings regardless of whether the auditor was thorough On the other hand, the financials could be of such low quality that even the best auditor may not be able to catch everything and thus yield financials with lower earnings

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governance (Francis et al 2003), and audit markets (Choi and Wong 2004) are different around the world, making generalizations from one market to another difficult

Some countries have idiosyncrasies in their firm rotation policies rendering the results of studies done using this data problematic For example, Kim et al (2004) find support for mandatory firm rotation in Korea, but the Korean

government "appoints" the new external auditor for the firm when rotation is deemed to be "warranted." This "appointment" of an external auditor by the government would yield results that may not apply to a potential mandatory firm rotation policy in the United States, where the "new" auditor (following firm

rotation) may be decided by a competitive bidding process instead of government appointment

Two competing theories offer predictions regarding audit partners'

decision-making for a new client from outside the firm Economic theory

suggests audit firms "low-ball" (DeAngelo 1981) new clients in order to gain their business.4 Partners have an economic incentive to maintain their clients long enough to recoup the initially foregone profits, and therefore are more likely to acquiesce to a client's position regarding the audit findings This theory suggests that auditors have an economic incentive to be less independent for new clients under firm rotation than partner rotation However, in a firm rotation scenario, an

4 "Low-balling" refers to the idea that audit firms reduce fees in order to gain the client's business, even if it means taking a loss on the client in the initial years of the engagement As the

relationship continues, the auditor becomes more efficient in auditing the client, reducing costs and possibly raising the fee, with the result being that the auditor is now turning a profit on the

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audit firm would have less time to recoup foregone profits, which may in turn mitigate the low-balling effect

On the other hand, Social Identity Theory predicts that auditors should be more willing to acquiesce to partner-rotated clients due to their identification with the client (Ashforth and Mael 1989) This is because a firm-rotated client is seen

as a member of the "outgroup," as the partner has less history and familiarity with the firm compared to partner-rotated firms Thus, Social Identity Theory would predict auditors would be less independent under partner rotation than firm

rotation

Additionally, I study a potential effect of requiring auditors in the U.S to sign their names to the publicly disclosed audit report This potential requirement

is currently being discussed by the PCAOB (2009) The thinking behind this idea

is that requiring the partner to sign the publicly disclosed audit report will increase partners' perceptions of their accountability, which will result in increased

independence Although accountability measures known a priori by participants

have resulted in greater conservatism (DeZoort et al 2006), it is unknown if the signing requirement will influence auditor behavior, as audit partners are already required to sign their names to the audit report.5 The proposed standard would

change the partner's signature to one that is publicly disclosed More

importantly, will the signing requirement mitigate any differences in

independence levels? If so, implementing the signing requirement of the publicly

5 In current practice, the lead engagement partner signs his/her name giving permission for the audit report to be released to the public However, the signature does not appear on the public copy of the audit report itself Thus, financial statement users cannot identify the lead

engagement partner from the audit report The proposed standard would require the lead

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disclosed audit report could be a way to ensure higher quality audits under partner rotation without requiring firm rotation

Contribution

This dissertation contributes to the academic field by presenting evidence

on the comparison between auditors' independence for a client rotated in from another partner versus one rotated in from an outside firm There has been scant research into this area, and almost none at the experimental level

Providing evidence about governing bodies' claims that partner and firm rotation provide substantially the same benefits will help assist in the development of research targeting the specific benefits and costs of partner versus firm rotation called for recently in the literature (Bamber and Bamber 2009, DeFond and Francis 2005)

Auditors strive to maintain objectivity and independence in their decision making (AICPA, 2010) Research uncovering situations in which they may not

be completely objective will aid their pursuit of conducting high quality audits Furthermore, the investigation into potential effects of requiring auditors to sign the publicly disclosed audit report contributes to practice, as it provides evidence

on whether having partners sign their names will result in increased

independence This has practical implications for two key issues being

discussed by governing bodies: 1) mandatory firm rotation and 2) requiring the lead engagement partner to sign the audit report I seek to shed light on both

issues by providing a priori evidence of the potential effects of implementing

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these requirements in practice and potentially inform both the PCAOB and the auditing practice as a whole when discussing potential implantation of new

standards

Organization

The remainder of this dissertation proceeds in the following manner:

Chapter 2 presents the literature review for this topic Chapter 3 develops the hypotheses and offers the methodology used in conducting this study Chapter 4 reports the results of the study Chapter 5 concludes with a summary discussion

of the dissertation, including limitations of the study and avenues for potential research

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Chapter Two: Literature Review

Organization

This chapter begins with an discussion of conflicts-of-interest encountered

by auditors How do these potentially inhibit independence? What incentives seek to promote independence and counter the effects of these conflicts-of-interest? This discussion is beneficial to understanding how my research

question(s) fits into the broader topic of auditor independence

Next, the chapter looks at relevant research related to audit firm and partner rotation Most published papers have approached the question of firm rotation by examining audit tenure from an archival-based method using U.S data This approach, however, has not addressed partner rotation Social Identity Theory is discussed next, focusing on organizational, professional and client identification, and identification in audit research The chapter concludes with a section on accountability and how accountability interacts with

identification

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Auditor Independence

Public trust is vital to the accounting profession's survival Financial statement users must believe that auditors will provide an independent, unbiased opinion on the client's financial statements (Moore et al 2006) Former Chief Justice Warren Burger echoed this sentiment when he wrote on behalf of a

unanimous U.S Supreme Court decision:

"By certifying the public reports that collectively depict a

corporation's financial status, the independent auditor

assumes a public responsibility transcending any

employment relationship with the client The independent

public accountant performing this special function owes

ultimate allegiance to the corporation's creditors and

stockholders, as well as to the investing public This "public

watchdog" function demands that the accountant maintain

total independence from the client at all times and requires

complete fidelity to the public trust." (Burger 1984)

The idea that auditors and other professionals would face conflicts of interest is not surprising What makes the conflicts of interest especially

dangerous for auditors in particular is that the existence of the profession relies

on its independence The AICPA emphasizes the need for independence in its Code of Professional Conduct:

"In the performance of any professional service, a member

shall maintain integrity, shall be free of conflicts of interest,

and shall not knowingly misrepresent facts or subordinate

his or her judgment to others." (AICPA Code of Professional

Conduct, Rule 102.01)

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Constraints inhibiting auditor independence

Those who argue against the likelihood of auditor independence state that true independence is impossible due to a system where auditors are given

incentives to please their clients (Bazerman et al 2006) When an auditor

submits a bid for a potential new client, the auditor knows there will be

(sometimes significant) start-up costs involved The auditor must invest time and money to learn a client's accounting system, internal controls, business model, and (perhaps) industry However, in a competitive market, the auditor wants to obtain the client and thus will often bid the initial fee below cost in order to win the client (DeAngelo 1981) This practice of "low-balling" helps the auditor win the client's business

As the auditor continues to audit the client in future years, the production costs of the audit will decline as the auditor becomes familiar with the client and the client's accounting system This potentially allows improved efficiency in conducting the audit This, in turn, creates a situation where production costs decline and fees potentially increase creating a "quasi-rent" to the auditor for future engagements (DeAngelo 1981) This practice of "low-balling" can create economic incentives that affect auditor independence For example, these

economic incentives may lead an auditor to ultimately issue an inappropriate unqualified opinion, waive material adjustments6, and concede to the client on financial reporting decisions (Geiger and Raghunandan 2002)

"Waiving adjustments" refer to the situation where the auditor proposes changes to the financial statements based upon the results of the audit (through adjusting journal entries), but eventually

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Another incentive that works against auditor independence is the audit firms' drive for profitability and growth In the 1980's, mergers took place among large accounting firms (e.g., Deloitte Haskins & Sells and Touche Ross merged

to form Deloitte & Touche) These mergers were part of a larger plan to provide nonaudit services, grow market share, and generate profits (Zeff 2003) This company-wide focus on profits and growth sent a message that bringing in new clients, keeping old ones, and selling nonaudit services (e.g., consulting and tax services) were of great importance

However, the biggest threat to auditor independence may not be any direct threat, but rather a slow, gradual, unconscious process

"The greatest threat to his independence is a slow, gradual,

almost casual erosion of this honest disinterestedness - the

auditor in charge must constantly remind his assistants of

the importance and operational meaning of independence."

(Mautz and Sharaf 1961)

Mautz and Sharaf (1961) explain the auditing profession has "built-in"

anti-independence factors that constantly fight against (and erode) the auditor's independence They cite the close relationship the auditing profession has with business (often over a period of many years), the reliance on the client for future revenues, the existence of a confidential relationship, and a strong emphasis on service to management For instance, with respect to building a relationship with

a client over many years, Johnson (2010) reports that all of the top 100 lasting auditor-client relationship are in excess of 50 years, while each of the top

longest-10 relationships are in excess of longest-100 years

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Despite the fact that audit failures occur, it would be cynical to claim that behind every audit failure is a corrupt audit partner and audit firm.7 More likely, problems in audits arise from a gradual accumulation of professional pressures

to slant conclusions, a process termed "moral seduction" (Moore et al 2006) This gradual moral seduction would explain auditors' attitudes about potential conflicts of interest "Most professionals feel that their professional decisions are justified and that concerns about conflicts of interest are overblown by ignorant or demagogic outsiders who malign them unfairly" (Moore et al 2006, p 11)

"We take the existing independence rules quite seriously and

consequently abide by all existing rules We are

professionals that follow our code of ethics and practice by

the highest moral values We would never be influenced by

our own personal financial well being versus our professional

ethics." (Shamis 2000)

Incentives encouraging auditor independence

Despite the incentives for auditors to be biased in their decision-making, there are incentives for auditors to be objective Auditors face potential civil and criminal liabilities in the event of an audit failure Auditors face regulatory

sanctions by the SEC, PCAOB, and state regulators if found negligent in

conducting an audit These accountability incentives relate to professional

reputation loss that could severely inhibit future revenues Auditors also have a

7 DeAngleo (1981) defines an audit failure as having two components: 1) a material error must appear in the financial statements and 2) the auditor must fail to correct it In practical research, this definition is difficult to operationalize, which leads to proxies being used For instance, Geiger and Raghunandan (2002) define an audit failure as an occurrence where a) the auditor gives the client a clean opinion in a given year and b) the client files for bankruptcy the following

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professional code of ethics that gives them an incentive to act in an unbiased fashion (Nelson 2006)

DeAngelo's (1981) definition of an audit failure has two components: the misstatement must be in the financial statements, and the auditor must fail to require its correction (either by not detecting it or by detecting it but waiving the necessary adjustment) The case usually made against auditor independence focuses on the auditor failing to require the correction (the second part of

DeAngelo's definition) while the first part (material error must be present in the financial statements) is often ignored Yet, auditors cannot find an error that does not exist Clients with incentives for accuracy develop and maintain better internal controls and pressure clients less (Nelson 2006) For example, the SOX requirement of CEO/CFO certification8 of the financial statements (under

potentially criminal prosecution) provides an incentive for top management to desire accuracy, which would decrease the number of material errors9 entering the financial statements prior to the audit Thus, an often overlooked part of the independence argument is that incentives can not only encourage auditor

independence but can also lower the number of material errors that enter the statements initially

CEOs and CFOs have always had responsibility for their company's financial performance, but SOX requires them to certify that they have designed effective controls and provided accurate financial reports, and to face a wider variety of financial, criminal, and civil penalties should those certifications later be proven inaccurate (SOX section 302, Nelson 2006)

9 When planning to audit a client, an auditor will establish a materiality threshold This threshold represents the dollar amount by which any errors found in excess to be "major" errors and

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Auditor rotation and independence

While incentives to maintain independence battle against incentives to yield to client pressure, the outcry for reform to the current auditing system has been intensified by recent audit failures, accounting scandals, and corporate fraud (Raiborn et al 2006, Byrnes 2002) A proposed "fix" to the apparent lack of auditor independence in these cases is audit firm rotation.10 Audit firm rotation refers to the concept that audit firms would only be allowed to audit clients for a fixed number of years After this time, the firm must "rotate" off the audit,

relinquishing it to another firm The concept is seen as a cure for the incentives fighting auditor independence, as auditors would not be able to develop long-lasting relationships with clients

The idea of mandatory rotation surfaced at least as far back as the late 1930s, with hearings being conducted in regards to the McKesson and Robbins fraud (Baxter 1999) Rotation was a major issue discussed in the 1976 Metcalf report about the accounting profession's structure and independence (Walker et

al 2001) Most recently, the possibility of requiring audit firm rotation was

discussed in hearings prior to the passage of the Sarbanes-Oxley Act in 2002 (GAO 2003)

Opponents of mandatory rotation cite the increasing costs of conducting

an audit that would occur in a mandatory rotation scenario Auditing a new client requires an investment of time and personnel to learn the specific client's

business model, industry, technology, accounting system, etc Implementing

10 "Mandatory audit firm rotation", "audit firm rotation", and "firm rotation" are used

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mandatory rotation would cause audit firms to incur these costs over a fixed (and

in many cases, shorter) period of time, increasing the cost recognized in a given year (e.g., Chi et al 2009, Blouin et al 2007, Myers et al 2003)

Audit quality may also decrease in a mandatory rotation system Audit firms have a learning curve when engaging a new client, and it often takes 2-3 years to fully learn a client's system (Daugherty et al 2010) Research also indicates that audit failures most often occur in the early years of an audit

relationship (AICPA 1992, Carcello and Nagy 2004, Davis et al 2009)

Lastly, opponents of mandatory firm rotation argue that the current (U.S.)

system of mandated partner rotation, where the lead partner on an audit

engagement is required to rotate every five years, is sufficient to achieve the benefits of a firm rotation system (AICPA 1992, GAO 2003) Despite this claim, little research has been conducted to investigate whether the benefits are indeed the same

Audit Firm and Partner Rotation

Introduction

Since the release of the GAO's (2003) study, many researchers have investigated the question of audit firm rotation and independence in order to

provide a priori evidence of possible consequences A popular archival-based

method of addressing this question has been to look at associations between audit firm tenure and audit quality Audit quality is unobservable, so a proxy must

be used to measure this construct In the archival literature, abnormal accruals

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are often used as a proxy for earnings quality (Healy and Wahlen 1999).11 In turn, high earnings quality is thought to be the result of high quality audits,

rendering abnormal accruals as a popular proxy for audit quality in recent

literature (Bamber and Bamber 2009)

Numerous studies conducted using U.S data have examined the

relationship between firm tenure and audit quality (Myers et al 2003, Johnson et

al 2002, Mansi et al 2004, Ghosh and Moon 2005) as a way of indirectly

addressing the firm rotation question Audit firm rotation is not required in the United States Therefore, these authors look at the relationship between firm tenure and audit quality to see if audit quality is higher in the early years of an audit engagement and/or decreases as tenure increases, both of which would be indicators in support of firm rotation On the other hand, lower audit quality levels

in the initial years of the engagement and/or steady/increasing audit quality as tenure increases would be indicators that firm rotation is not warranted

Audit firm rotation

The studies that have indirectly examined the relationship between audit quality and firm tenure have not only used abnormal accruals as a proxy for audit quality, but various other proxies as well These include audit failure (Geiger and Raghunandan 2002), whether companies were charged with fraudulent reporting (Carcello and Nagy 2004), cost of debt financing (Mansi et al 2004), the

likelihood of the auditor issuing a going concern opinion (Knechel and

11 Abnormal accruals are the difference between "expected" accruals and total accruals, first used

in Jones (1991) Modern researchers use abnormal or "unexpected" accruals as an indicator of

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Vanstraelen 2007), financial statement restatements (Stanley and DeZoort

2007), earnings response coefficients (Ghosh and Moon 2005), meeting or

beating earnings benchmarks (Davis et al 2009), and shareholder ratification votes for the auditor (Dao et al 2008)

In addition, a number of studies have examined direct effects of audit firm rotation and quasi-firm rotation scenarios From the archival perspective,

researchers have tested the forced rotation of firms following the collapse of Arthur Andersen (Cahan and Zhang 2006), firms in foreign countries under a mandatory firm rotation rule (Cameran et al 2009), and clients who voluntarily switch audit firms (Jackson et al 2007) Experimentally, researchers have tested the effects of auditors' reported values of a given asset (Dopuch et al 2001), auditors' proposed adjusting entries (Hatfield et al 2007), investors' predictions

of reported EPS (Kaplan and Mauldin 2008), and loan officers' perceptions of auditor independence (Daniels and Booker 2006)

The majority of the results, especially from an archival perspective, do not support the proposed change to mandatory rotation Of the 29 recent papers I've included in this dissertation, 19 have results that do not offer evidence supporting mandatory rotation From an archival perspective, 17 of 24 papers do not offer support The experimental literature is reversed, with 3 of 5 papers offering evidence supporting firm rotation However, two points must be made in regards

to the experimental findings First, the experiments compare firm rotation to no rotation (Wang and Tuttle 2009) rather than firm to partner rotation The archival

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papers are using data where audit partner rotation is already in effect (e.g., the U.S.)

Thus, behavioral experiments directly compare firm rotation to no rotation, while archival papers often look at an environment where partner rotation is in use and draws conclusions about potential firm rotation effects Therefore, comparisons between the two are somewhat difficult since firm rotation isn't being compared to the same thing in both cases Second, the overall sample size of the experimental papers (five) is quite small Again, this makes drawing comparisons difficult between the two styles of research

Research not offering support for mandatory rotation has generally found that audit quality is lower during the initial years of the engagement compared to other years and/or audit quality increases (or at least does not decline) as firm tenure increases Geiger and Raghunandan (2002) find a positive relationship between firm tenure and the likelihood that a bankrupt company received a going concern opinion the previous year This means that the longer an auditor serves

a client, the more likely the auditor is to give a going concern opinion the year before the client declares bankruptcy The findings suggest that auditors who have served clients for less time are less likely to give a going concern when the client goes bankrupt the following year The implication of this research is that audit firm rotation would not result in improved audit quality, as it is the auditors with longer tenure who have higher audit quality

Johnson et al (2002) finds lower earnings quality for clients with less than three years of tenure when compared to "medium" and "long" tenure groups,

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while Myers et al (2003) finds that earnings quality increases with tenure Chen

et al (2008) find a similar result for earnings quality using a sample of Taiwanese companies Carcello and Nagy (2004) report that fraudulent financial reporting is more likely to occur in the first three years of an audit Knechel and Vanstraelen (2007) find that auditors do not become less independent over time, measuring independence as the likelihood of issuing a going concern opinion Shafie et al (2009) confirm Knechel and Vanstraelen's findings for a sample of Malaysian companies, as do Ruiz-Barbadillo et al (2009) for Spanish companies

The Ruiz-Barbadillo et al (2009) paper is of particular interest, as the sample is made up of Spanish companies Spain is a country that had a

mandatory firm rotation policy, so at first glance it seems like an ideal setting to examine the firm rotation question However, although Spain formally enacted a firm rotation policy (1988), firm rotation never took place, as the law was

repealed (1995) before the first rotations were to begin (1997) (Table 2.1 lists countries that currently have mandatory firm rotation requirements.) The

authors attempt to counteract this objection by explaining that their data are drawn from a time when audit firms expected firm rotation to occur, so their

behavior is indicative of behavior under an actual firm rotation regime However,

it is plausible to believe the firms had at least some hint that the law would be repealed well before it was actually repealed, and thus the firms' behavior may not truly reflect a firm rotation scenario

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Table 2.1 - Countries under Current Mandatory Firm Rotation

Companies required to rotate

Banks and listed companies Banks, privatized insurance companies, and government companies

Listed companies and some other firms identified by law Banks incorporated in Singapore

Companies listed in KSE (Korean Stock Exchange) or registered with KOSDAQ (Korean Securities Dealers Automated Quotations)

Sources: Cameran et al 2009, Cameran et al 2005

Another country where mandatory firm rotation is in place and has

occurred is Italy, where Cameran et al (2009) report on audit quality Again, this appears to be an ideal place to study the mandatory firm rotation question, as

firm rotation is required and it has occurred, unlike the Spanish study However,

this research has its own set of difficulties The Italian firm rotation system has

both a rotation element and a retention element The retention element states

the once hired, an audit firm may not be replaced for three years The contract can be renewed twice, making a maximum audit firm tenure of nine years for any single client The inclusion of the retention element adds a variable that likely affects the rotation system (Dopuch et al 2001)

In the Cameran et al (2009) study, the authors study the tenure of audit firms in three-year windows, corresponding to the three-year contracts signed under the retention element They observe discretionary accruals declining over that three-year window and conclude that firm rotation is not warranted since accruals decline over time However, Daugherty et al (2010) report auditors

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require 2-3 years to learn a new client's accounting system, internal controls, etc This "learning effect" could explain the higher accruals during the first years of the Italian sample, as auditors would be less likely to catch as many errors to do

a pronounced information asymmetry

To this point, many papers have reported results offering no evidence of a need to switch to mandatory firm rotation Despite the multitude of findings, there are reasons to question those findings Papers using dependent variables such

as going concern opinions and audit failures are looking at a very small sample

of the overall audit market, as the number of audit failures and going concern opinions occurring each year is quite small (Bamber and Bamber 2009)

Researchers using accruals as a proxy for audit quality are relying on the ability

of the accruals measure to capture audit quality, which may not be realistic (Chi

et al 2009) For example, the use of accruals to measure audit quality is

implying that the abnormal accruals were not only used to manage earnings, but that those earnings should have been detected and corrected by the auditor Furthermore, the use of abnormal accruals is suggesting that the researchers themselves are finding things that the auditor did not, though the auditor has first-hand knowledge of the audit, while researchers are looking at previously reported data

Some research has focused not on measures of audit quality, per se, but

on investors' perceptions of audit quality After all, auditing exists to provide

assurance as to the quality of the financial statements (Moore et al 2006) It is ultimately the users of the financial information that make the decision about the

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quality of the information and, therefore, the quality of the audit Ghosh and Moon (2005) examine earnings response coefficients, the influence of reported earnings on stock rankings, and the influence of past earnings on one-year-ahead forecasts and find that all three are positively associated with tenure However, Dao et al (2008) find that shareholders are more likely to vote against auditor ratification for auditors with longer tenure, suggesting that shareholders perceive audit firms with longer tenure as being less independent Daniels and Booker's (2006) experimental results showed that the presence of an internal rotation policy significantly enhanced investors' perceptions of auditor

independence

In addition to the Dao et al (2008) study, there are studies that offer evidence in support of mandatory firm rotation Davis et al (2009) identify a sample of firms that would have missed their earnings forecasts without their discretionary accruals but beat the forecasts with the use of those discretionary accruals They argue that if earnings management is taking place through the use of discretionary accruals, it would be these companies whose management would have an incentive to do so They find that discretionary accruals are at higher levels for both audit firms with short tenure (three years or less) and firms with longer tenure (14 years or more) The result for the firms with short tenure could be explained by the "low-balling" effect or the "learning effect." This

nonlinear relation between firm tenure and audit quality was also found by Chi and Huang (2005), who included a tenure squared variable in their regression to allow for the nonlinearity of this relationship Their results are the same as Davis

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et al (2009); namely, that accruals were higher during the initial years of an audit, decreased over time, but then increased again at a point Chi and Huang label "excessive familiarity" (page 90)

In addition to examining indirect associations between audit quality and firm tenure, other researchers have attempted to answer this question directly Archival-based research has capitalized on instances of involuntary firm rotation

to study potential effects of firm rotation, while experimental research has

attempted to isolate and measure decision-making under a firm rotation policy

An academic consequence following the collapse of Enron and Arthur

Andersen was the opportunity afforded to study a de facto firm rotation, as all of

Andersen's clients had to find new auditors following the firm's demise Nagy (2004) found that for smaller clients (but not larger ones) audit quality improved following the "rotation." Cahan and Zhang (2005) also looked at the former-Andersen clients, but included variables to control for litigation concerns of the new clients The authors found that ex-Andersen clients had lower levels and larger decreases of abnormal accruals relative to a control sample also audited

by a Big 4 auditor These results suggest that firm rotation would result in higher audit quality, as the "new" ex-Andersen clients had higher quality earnings than control clients from the same auditor However, Blouin et al (2007) used a unique dataset, which allowed them to track whether former Andersen clients followed their old audit team to the "new" auditor, and found that after controlling for this, there was no evidence that audit quality improved

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A couple of other archival working papers look at other settings where firm switching has occurred Kim et al (2004) find that clients with new auditors under a Korean rotation system have significantly lower discretionary accruals However, the Korean system is one where the government identifies firms that have "high risk" factors for earnings management and forcibly replaces their current auditor with a government appointed one Generalizing this system to a potential U.S rotation system would be difficult, as any potential rotation system

in the U.S is not likely to include this Korean feature Jackson et al (2007) investigate Australian clients who have voluntarily switched firms and report that audit quality does not improve as a result of the voluntary switch

In the experimental realm, Dopuch et al (2001) have the seminal paper investigating firm rotation and retention In a 2 x 2 design with firm rotation and retention as the manipulations, the authors examine participants' propensity to issue client-preferred reports They find that auditors are more independent in a rotation-only scenario and most independent in a rotation and retention setting, which is similar to the current Italian auditing requirements Their findings

suggest that auditors are more independent under mandatory rotation, though they also find that clients choose to invest more in their assets when rotation requirements are not present Wang and Turtle (2009) build on this work by examining the negotiation process under a mandatory firm rotation scheme They confirm Dopuch et al.'s (2001) finding of more independent reporting under mandatory rotation The authors contribute to the literature by showing auditors are less willing to compromise, leading to values being reported closer to the

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auditors' desired amounts They also find mandatory rotation results in more negotiation impasses Their experiment uses students as participants instead of auditors, so the generalizability of the results are called into question as students

do not have the same level of experience and accountability as auditors do in negotiations

Archival partner rotation

Studies on partner rotation are a nascent addition to the rotation debate, with work dating back only five years (approximately) As with firm rotation, researchers examine the issue indirectly, using proxies for audit quality, and directly, using data that reveal partner switches The archival-based papers all use samples outside of the U.S., since domestic rules do not require the lead partner's name to be publicly disclosed Audit partners' names are publicly disclosed in Taiwan and Australia, allowing data to be gathered on partner

switches

Chi and Huang (2005) use Taiwanese data to study the association

between accruals and partner tenure They find that "excessive" partner tenure results in higher levels of accruals.12 Chen et al (2008) report that accruals decrease with partner tenure, though their model assumes a linear relationship that Chi and Huang (2005) do not Chi et al (2009) find that audit quality

decreased following the implementation of a mandatory partner rotation policy

12 This is the same paper found in the Firm Rotation section of this literature review Although they find an association between accruals and partner tenure, they emphasize the finding

between accruals and firm tenure, suggesting that regulatory bodies should consider firm tenure

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