casterella and johnston - 2013 - can the academic literature contribute to the debate over mandatory audit firm rotation [mafr]

As a result, it is unclear that these results would extend to a regulatory regime where audit firm rotation is mandatory.2 In this paper we compare studies that are based on vol-untary au

Research Report

Can the academic literature contribute to the debate over

mandatory audit firm rotation?

Jeffrey R Casterellaa,b,⇑, Derek Johnstona

a Colorado State University, Fort Collins, CO, USA

b University of Auckland, Auckland, New Zealand

Article history:

Available online 11 January 2013

Keywords:

Audit firm rotation

Independence

Audit quality

a b s t r a c t

Recently, the Public Company Accounting Oversight Board (PCAOB) issued a concept release soliciting public recommendations to improve auditor independence and audit quality (PCAOB, 2011) The focus of the release is on mandatory audit firm rotation (MAFR) with a request for commentaries addressing the advantages and disadvantages of MAFR In this paper, we briefly summarize the recent literature on mandatory audit firm rotation and suggest how it can be useful to regulators as they consider the implementation of man-datory rotation We find that the conclusions reached about the possible effectiveness of MAFR appear to depend on the type of data used (voluntary vs mandatory auditor changes), suggesting that regulators should exercise care when drawing inferences from past audit firm rotation research

Ó 2012 Elsevier Ltd All rights reserved

Introduction

Recently, the Public Company Accounting Oversight

Board (PCAOB) issued a concept release soliciting public

recommendations to improve auditor independence and

audit quality (PCAOB, 2011) The focus of the release is

on mandatory audit firm rotation (MAFR) and the PCAOB

requests commentaries addressing the advantages and

dis-advantages of MAFR.1 In March of 2012, the PCAOB

con-ducted 2 days of hearings on the pros and cons of MAFR

The hearings featured several former regulators who ad-dressed the costs and benefits of MAFR There was little con-sensus While former Federal Reserve chairman Paul Volcker said his experience ‘‘does suggest to me the importance of requiring rotation’’ (Tysiac, 2012), former SEC chairman Breeden seemed less convinced saying that ‘‘mandatory rotation would benefit some companies and it would prob-ably harm others’’ (Chasen, 2012) Charles Bowsher, former U.S comptroller general, suggested a limited MAFR arrange-ment that would apply to only the largest 25 or 40 publicly traded companies Finally, former SEC chairman Harvey Pitt expressed concern that with MAFR, ‘‘the cure could turn out

to be worse than the disease, depending on the amount of time people would be required to rotate off’’ (Cohn, 2012) Given the opposing views on MAFR, the purpose of this pa-per is to provide a critical summary of recent research and suggest how it might be useful to regulators as they consider the implementation of mandatory rotation in the U.S

In an extensive review of the research examining the causes and consequences of auditor switching,Stefaniak, Robertson, and Houston (2009)note that most studies look

at the association of auditor tenure and various measures

of audit quality In general, they find that audit quality is 1052-0457/$ - see front matter Ó 2012 Elsevier Ltd All rights reserved.

⇑ Corresponding author at: College of Business, 253 Rockwell Hall,

Colorado State University, Fort Collins, CO 80523, USA Tel.: +1 970 217

0947.

E-mail address: Jeff.Casterella@colostate.edu (J.R Casterella).

1 This represents the second time in 10 years that regulators at the

federal level have formally considered the implementation of MAFR In

2003, the U.S General Accounting Office (GAO) concluded that the

Securities and Exchange Commission (SEC) and the PCAOB should not

consider mandating audit firm rotation until the full effects of the

Sarbanes–Oxley Act of 2002 could be assessed The GAO report also noted

that, in the future, the PCAOB will likely need to ‘‘ evaluate whether

further enhancements or revisions, including mandatory audit firm

rota-tion, may be needed to further protect the interest and to restore investor

confidence’’ ( GAO, 2003, p 5 ).

Contents lists available atSciVerse ScienceDirect Research in Accounting Regulation

j o u r n a l h o m e p a g e : w w w e l s e v i e r c o m / l o c a t e / r a c r e g

higher when there is a longer auditor–client relationship, a

finding that would seem to mitigate against a policy of

MAFR (DeFond & Francis, 2005; Stefaniak et al., 2009)

The problem with this inference is that most of these

stud-ies use data from a regulatory regime in which changing

auditors is voluntary (as is currently the case in the United

States) As a result, it is unclear that these results would

extend to a regulatory regime where audit firm rotation

is mandatory.2

In this paper we compare studies that are based on

vol-untary auditor changes with those that are based on

man-datory or quasi-manman-datory auditor changes3 since it

appears that the PCAOB is especially interested in studies

involving the latter.4We find that the conclusions reached

about the possible effectiveness of MAFR depend on the type

of data used, suggesting that policy makers exercise caution

when drawing inferences from academic research

The remainder of the paper is organized as follows In

the next section, we provide a brief summary of the MAFR

debate, and discuss how the academic community has

re-sponded to calls for research concerning the potential

ben-efits of MAFR In Section ‘Evidence on mandatory audit

firm rotation’, we briefly summarize the evidence from

the academic research, with a focus on differentiating

those academic studies that use voluntary changers data

from those that employ mandatory rotators data

Sec-tion ‘Summary and discussion’ concludes with a discussion

of the implications that these two subsets of the audit firm

rotation research have on the MAFR debate

The debate and the academic response

The arguments for and against mandatory audit firm

rotation are well-documented.5 Proponents of MAFR

be-lieve that long-tenure auditor–client relationships increase

the likelihood of audit failures This belief is based on the

assumption that a long-tenure relationship leads to an

in-creased level of familiarity between the two parties that

nat-urally erodes auditor independence and professional

skepticism.6 Hence, proponents believe that audit firms

should be required to roll-off engagements after a fixed

per-iod of time Such a policy would prevent the existence of any

long-tenure auditor–client relationships which would, they

argue, decrease the number of audit failures Conversely,

opponents of MAFR point out that audit firms gain valuable

knowledge about their clients over time As a result,

oppo-nents express concern that a mandatory rotation policy

would result in a lack of client-specific knowledge, causing short-tenure auditor–client relationships to be more prone

to audit failures

Table 1summarizes the various types of auditor–client relationships that would exist with and without a MAFR policy In particular, the table describes audits in terms of mandatory rotation regime (yes/no) and auditor tenure (short/medium/long) For purposes of this table, we define short-tenure relationships as those between 1 and 3 years, medium between 4 and 6 years, and long as 7 years or longer.7Since the U.S does not have a MAFR requirement, auditor–client relationships in the U.S can be either short, medium, or long (cells 3, 4 or 5) Conversely, in a regime with mandatory rotation, no long-term auditor–client tionships would exist, leaving only short and medium rela-tionships (cells 1 and 2)

If the United States were to adopt a rotation policy, long-tenure audits (cell 5) would be forced into short-ten-ure audits (cell 1) Proponents argue that such a shift would result in higher audit quality due to enhanced audi-tor independence In contrast, opponents believe that audit quality would decline because the new auditor would lack experience with the client Put simply, proponents of MAFR argue that short-tenure auditor–client relationships will result in higher quality audits, while opponents of MAFR argue that short-tenure auditor–client relationships will result in lower quality audits

The goal of research in this area is to provide evidence regarding the potential effect of mandatory rotation on the quality of audits conducted on U.S companies Ideally, one would compare measures of audit quality from cell 5 audits with those from cell 1 audits Because the U.S does not have a mandatory rotation policy in place, the neces-sary data from cell 1 audits for U.S public companies is not available To circumvent this data issue, most studies substitute cell 3 data for cell 1 data Generally speaking, these studies analyze the differences in various measures

of audit quality between cell 5 and cell 3, and find that the quality of cell 5 audits are, on average, significantly better than the quality of cell 3 audits Based on that evi-dence alone, one would conclude that a mandatory rota-tion policy would have a negative effect on audit quality, resulting in a higher occurrence of audit failures

This is where the data is issue is important By replacing cell 1 audits with cell 3 audits, these studies rely on the assumption that the characteristics of companies with auditor relationships that fall into cell 3 are similar to those that would have short-term auditor relationships in

Table 1 Types of auditor–client relationships by mandatory rotation regime Mandatory

rotation regime?

Short-tenure (e.g., 63 years)

Medium-tenure (e.g., 4–6 years)

Long-tenure (e.g., P7 years) Yes Cell 1 Cell 2 Not applicable

2

In fact, the PCAOB points out this limitation of the academic literature

on p 16 of its concept release.

3

We use the term ‘‘quasi-mandatory data’’ to characterize the data

gathered from controlled experiments that are designed to mimic a MAFR

environment.

4

Throughout the manuscript, we refer to new audits created in a MAFR

regime as ‘‘rotators’’ and new audits stemming from voluntary switching

decisions as ‘‘changers’’.

5

See Stefaniak et al (2009) for a review of the advantages and

disadvantages of MAFR.

6

See Previts (1998) for a review of auditor independence, its origins and

the potential for auditor conflicts of interest In addition, Kleinman, Palmon,

and Anandarajan (1998) provide an extensive review of studies that

7

Of course, the specific number of years used by the regulator to classify each relationship could be different from those that we use Related to this point, the PCAOB asks for input regarding the ‘‘appropriate term length’’ for

a mandatory rotation regime Since cell 3 audits represent

new auditor–client relationships that have been created

voluntarily, rather than via a mandatory rotation policy,

this assumption is likely invalid For example,Walker,

Le-wis, and Casterella (2001)show that companies that

vol-untarily change auditors differ significantly from a

random sample of companies More specifically, their

anal-ysis suggests that voluntary changers are more likely to

have fraud and be financially distressed Moreover,Carey,

Geiger, and O’Connell (2008)find that companies are more

apt to voluntarily change auditors following qualified audit

opinions.8Given the ample empirical evidence that suggests

that companies that voluntarily change auditors are already

‘troubled’ companies, it is not surprising that prior research

finds that the quality of cell 5 audits is higher than cell 3

audits, even after attempting to control for the determinants

of the decision to voluntarily change auditors For this

rea-son, Carcello and Nagy (2004) caution that it is unclear

whether the empirical results obtained from studies based

on voluntary changers would extend to a MAFR setting

In summary, the MAFR literature seems to rely heavily

on the use of cell 3 audits (i.e., voluntary changers);

never-theless, some studies exploit settings that may be more

representative of a mandatory rotation regime In the next

section, we briefly summarize the findings of prior rotation

research, with a focus on differentiating studies based on

the type of data employed

Evidence on mandatory audit firm rotation

TheAppendixsummarizes, in chronological order, the

key findings from 24 audit firm rotation studies from the

year 2001 to present For brevity’s sake, we limit the

Appendixto empirical archival and experimental research

studies published in the top 25 accounting journals as

determined byGlover, Prawitt, and Wood (2006).9For each

study, theAppendix provides information on the relation

examined, sample used, and primary results

DeFond and Francis (2005)andStefaniak et al (2009)

conclude that the majority of extant research does not

pro-vide epro-vidence to support the introduction of MAFR in the

U.S as a means to enhance audit quality One can reach a

similar conclusion based on a cursory review of the

Appen-dix In 16 of the 24 studies, there is no evidence to support

the introduction of mandatory rotation On the contrary,

they bolster the argument that new audits may be

prob-lematic because of a learning curve effect Most of these

studies estimate regression models that associate audit

tenure with various measures of audit quality using data

from regimes where changing auditors is a voluntary,

rather than a mandatory, action In such settings, the

inclu-sion of a variable such as auditor tenure likely introduces

self-selection bias into the model Although there are

instrumental variable methods that one can use to correct

for this issue, they require assumptions about the data that may be unrealistic (Larcker & Rusticus, 2010)

We strongly suggest that policy makers recognize explicitly the difference between voluntary and mandatory auditor changes To this end, in Section ‘Evidence from studies using voluntary changers data’, we briefly summa-rize the key findings from the 13 studies that rely on data from voluntary changers to answer their research ques-tions In Section ‘Evidence from studies using mandatory rotators data’, we review the 11 studies that examine the potential benefits of audit firm rotation using mandatory rotators data

Evidence from studies using voluntary changers data Panel A of Table 2lists the 13 research studies that investigate the potential benefits of MAFR using voluntary changers (cell 3) data All of the studies are archival (rather than experimental), and most of these studies regress var-ious measures of audit quality on auditor tenure and a host

of control variables For example,Geiger and Raghunandan (2002) examine the association of auditor tenure with audit quality using a sample of 117 stressed companies that eventually filed for bankruptcy After controlling for factors such as firm size and the probability of bankruptcy, they find that as auditor tenure increases, the probability

of an audit failure decreases In addition,Johnson, Khurana, and Reynolds (2002) investigate the relation between auditor tenure and two measures of financial reporting quality (the absolute value of unexpected accruals and the persistence of accruals), and find that companies in short-term relationships (defined as 2–3 years) with their auditors have lower quality financial reports relative to companies that have been with their auditor for 4–8 years Similarly,Myers, Myers, and Omer (2003)document a neg-ative association between auditor tenure and the absolute value of discretionary accruals using a sample of U.S com-panies, a finding that was later confirmed byChen, Lin, and Lin (2008)based on a sample of Taiwanese companies Fi-nally, prior research using voluntary changers data finds that auditor tenure is: (a) negatively related to fraudulent financial reporting and firm risk (Carcello & Nagy, 2004; Crabtree, Brandon, & Maher, 2006; Mansi, Maxwell, &

Mill-er, 2004); and (b) positively associated with investors’ per-ceptions of earnings quality and conservative financial reporting (Ghosh & Moon, 2005; Jenkins & Velury, 2008)

Of the 13 studies that use voluntary changers data, only

Li (2010) and Chi, Ling Lei, and Mikhail (2011) provide modest support for a move to MAFR Specifically, using Big N audits over the period 1980–2004,Li (2010)finds that the reporting of conservative earnings is adversely af-fected by long-tenure audits of small companies and weekly monitored companies Moreover,Chi et al (2011)

examine, among other things, the association of auditor tenure with earnings management, and find conflicting re-sults Although they find that auditor tenure is negatively related to accrual earnings management, they document

a positive association between auditor tenure and real earnings management The latter result provides some support for mandatory audit firm rotation

8

See Stefaniak et al (2009) for a detailed discussion of the studies that

explore the determinants of firms’ decisions to change audit firms.

9

In addition we include published work from two journals dedicated to

auditing and/or the regulation of auditing and accounting: Research in

Accounting Regulation and International Journal of Auditing We also

Interestingly, of the 13 papers summarized in Panel A,

onlyLi (2010) appears to take steps to explicitly control

for the potential self-selection bias that may arise through

the use of voluntary changers data Specifically,Li (2010, p

239) points out that he ‘‘ controls for an endogeneity

problem possibly arising from the auditor tenure variable

which is often ignored in previous studies.’’10 The PCAOB

has voiced concern about studies that rely on samples of

companies that have voluntarily changed auditors, perhaps

because of the thorny econometric issues that can arise

when using such data With this in mind, we next discuss

prior research that exploits settings that are more consistent

with a regime of mandatory rotation

Evidence from studies using mandatory rotators data

Panel B ofTable 2lists the 11 studies that use

manda-tory rotators data (cell 1) Of the 11 studies listed, eight

provide support for MAFR As Panel B indicates, five of

the studies use archival data, while six use experimental

data We discuss the archival studies first, and then turn

our attention to the experimental studies

The demise of Arthur Andersen (AA) created a unique

setting to study the effects of audit firm rotation Although

not a perfect analogy to short-term audits that would be

obtained in a MAFR regime (i.e., cell 1 audits), we believe that the use of former AA clients is likely more representa-tive of mandatory rotators than are voluntary changers Three of the five archival studies listed in Panel B use the

AA setting to investigate the effect of rotation on audit quality, and provide mixed results In particular,Blouin, Grein, and Rountree (2007)focus on former AA clients that had extreme discretionary accruals while with AA Among other things, they find that moving to a new audit firm did not significantly curtail extreme income-increasing or in-come-decreasing discretionary accruals In contrast, the two other studies that use AA data provide evidence that lends some support to MAFR For example,Nagy (2005)

finds a significant increase in the audit quality of smaller

AA clients that were forced to find new auditors Also, Kea-ley, Lee, and Stein (2007)documents a positive association between the number of years that clients were with AA and the audit fee charged by the new auditor This result suggests that audit firms perceive a new client coming from a long-term relationship with its previous auditor

to be riskier than one coming from a short-term relation-ship with its predecessor auditor

The remaining two archival studies use true mandatory audit firm rotation data, and once again, provide mixed re-sults.Lowensohn, Reck, Casterella, and Lewis (2011) exam-ine the Florida government audit environment in which there exists: (a) both rotation and non-rotation regimes; and (b) an independent measure of the joint quality of the audit and of the financial statements of the reporting entity They find that, after controlling for other factors

Table 2

Mandatory audit firm rotation studies partitioned by setting.

Authors and publication date Method U.S or international data? Support for MAFR? Panel A: Studies using voluntary changers (cell 3) data

Ruiz-Barbadillo, Gómez-Aguilar, and Carrera (2009) a

Panel B: Studies using mandatory rotators (cell 1) data

a Since the mandatory rotation policy in Spain was never enforced, we consider the Ruiz-Barbadillo study as being conducted in a voluntary setting.

b To be more precise, Chi et al (2011) find conflicting results On the one hand, they find that auditor tenure is negatively associated with abnormal accruals Conversely, they show that auditor tenure is positively related to real earnings management.

c

Daniels and Booker (2011) report inconsistent results On the one hand, they find that the perception of independence is higher with MAFR Conversely, they show that perceptions of audit quality are neither higher, nor lower with MAFR.

10

Myers et al (2003) and Davis, Soo, and Trompeter (2009) attempt to

alleviate concerns about endogeneity with the removal of

‘‘quick-auditor-changer’’ companies from their analyses ‘‘Quick-auditor-changers’’ are

believed to be associated with reporting quality,

govern-ments that rotate issue higher quality reports.Kwon, Lim,

and Simnett (2010)investigate the impact of rotation on

audit quality in Korea, which began requiring audit firm

rotation in 2006 Their analysis suggests that while audit

fees increased upon adoption of the mandatory rotation

policy, the implementation did not have a statistically

sig-nificant effect on audit quality

Due to their controlled nature, experimental studies can

be particularly useful when it comes to examining the

ef-fect that mandatory rotation may have on auditor

indepen-dence and audit quality Of the six experimental studies

listed in Panel B, three investigate whether perceptions of

auditor independence are incrementally influenced by

MAFR Specifically,Jennings, Pany, and Reckers (2006)used

49 professional judges and find that auditor independence

perceptions are enhanced in a MAFR regime compared to

a regime that only rotates audit partners Similarly,Daniels

and Booker (2011)surveyed bank loan officers and find that

MAFR improves the perception of auditor independence

even though MAFR does not affect their perception of audit

quality In contrast,Kaplan and Mauldin (2008)show that

non-professional investors’ perceptions of independence

are not significantly enhanced in a MAFR regime (compared

to a regime that only rotates audit partners)

The remaining three experimental studies examine the

impact of mandatory rotation on the quality of the

subse-quent audits For example, Arel, Brody, and Pany (2006)

find that auditors in a MAFR regime are more likely to issue

modified audit opinions when a departure from GAAP is

present Likewise,Dopuch, King, and Schwartz (2001)find

that participants in a MAFR condition are less likely to

is-sue biased reports Finally,Wang and Tuttle (2009)

inves-tigate how MAFR affects auditor–client negotiations

Specifically, they find that in a mandatory rotation regime

auditors adopt less cooperative negotiation strategies and

are more likely to adopt ‘‘obliging’’ strategies in situations

when MAFR does not exist

Summary and discussion

Table 3 employs a simple 2  2 contingency table to

summarize the aforementioned 24 studies based on: (a)

whether the key findings provide support for or against a

mandatory rotation policy; and (b) whether the study

re-lied on mandatory rotators (cell 1) or voluntary changers

(cell 3) data.Table 3reveals that eight of the 11 studies

conducted in a mandatory rotation setting provide

evi-dence that lends support to a MAFR policy In stark

con-trast, only two of the 13 studies using voluntary changers

data provide support for mandatory audit firm rotation Crude statistical analysis consisting of a chi-square test for independence reveals that support for MAFR depends

on whether voluntary or mandatory data was used in the study (v2= 8.07, p-value < 0.01) Further, a simple odds-ra-tio computaodds-ra-tion reveals that that studies conducted in mandatory settings are 14.661 times more likely to find support for MAFR For numerous reasons, including the small sample size and lack of control variables, we realize that this analysis is far from rigorous.11 Nevertheless, it does lend some support to the concern expressed by the PCAOB and some academics regarding whether the empiri-cal results obtained from studies based on voluntary chang-ers would extend to a MAFR setting

The purpose of this manuscript is to provide a critical summary of recent mandatory audit firm rotation research and suggest how it might be useful to regulators as they consider the implementation of mandatory rotation in the U.S While Stefaniak et al (2009) conclude that ‘‘a majority of the evidence does not support the implementa-tion of a MAFR regime in the U.S.’’ (p 108, Secimplementa-tion 5.2.5),

we show that if one separates the literature into two sub-sets, the results found in the mandatory settings are much more supportive of MAFR In general, the first subset examines the effect of auditor tenure on audit quality in settings where changing auditors is a voluntary, rather than mandatory, action More often than not, the conclu-sion from this stream of the literature is that short-tenure audits have inferior audit quality compared to long-tenure audits However, it is questionable whether the findings of this stream of literature provide much useful guidance to the debate on MAFR because these studies rely on samples

of short tenure audits that are not representative of com-panies that would be forced to rotate under a MAFR regime

The second subset of the audit firm rotation literature also examines the association between auditor tenure and audit quality; however, these studies deliberately avoid the use of voluntary short-tenure audits and, instead, use short-tenure audits more likely to represent that which would exist under a mandatory rotation regime The majority of the studies from this subset of the literature are supportive of a move to MAFR, which is in stark con-trast to the conclusions reached from the studies that rely

on voluntary changers data Consequently, it appears that the conclusions reached about the possible effectiveness

of MAFR appear to depend on the type of data (voluntary

vs mandatory) used For this reason, we believe regulators should focus heavily on the type of data used in past audit

Table 3

Summary 2  2 contingency table Support for MAFR by setting.

Setting

Support for

MAFR?

Mandatory (use

cells 1 and 2)

Voluntary (use cells

3, 4, and 5)

Totals

11 We also estimate a logistic regression to assess whether studies conducted in mandatory settings are more apt to find results that support MAFR than studies conducted in voluntary settings Our dependent variable

in the model is SUPPORT, which is a dichotomous variable that equals one if the study’s key findings support MAFR, and zero otherwise The three independent variables in the model consist of: (1) MANDATORY, which assumes the value of one if the study used mandatory rotators data, and zero otherwise; (2) LOG_SIZE, which is the natural logarithm of the sample size on which the key findings in the study are based; and (3) ARCHIVAL, which equals one if the study was archival in nature, and zero otherwise The results (not reported) reveal that MANDATORY is positively related to

firm rotation research before extrapolating such research

to policy making decisions In addition, future MAFR

re-search should avoid the use of voluntary changers that

are known, ex ante, to be different from a random sample

of companies and instead focus on settings that are more

indicative of a regime with a MAFR policy

Acknowledgement

We appreciate the guidance and input from Barry Lewis and Robert Knechel We also appreciate the helpful com-ments from Ken Bills and the research assistance of Stephen O’Dorisio

Appendix A A summary of the audit firm rotation literature from 2001 to present

Authors and date Relation examined Sample Primary results Support

for MAFR?

Dopuch et al (2001) Audit firm tenure and

willingness to issue biased reports

An experiment with

72 manager subjects and 72 auditor subjects

Auditor independence

is higher in the presence of mandatory audit firm rotation

Yes

Geiger and Raghunandan

(2002)

Audit firm tenure and audit reporting failures

US audits of soon-to-be-bankrupt

companies between

1996 and 1998

Longer tenure is negatively associated with audit failures

No

Johnson et al (2002) Audit firm tenure and

financial reporting quality

US audits between

1986 and 1995

Longer tenure does not reduce financial reporting quality

No

Myers et al (2003) Audit firm tenure and

earnings quality

US audits between

1988 and 2000

Longer tenure does not reduce audit quality or earnings quality

No

Carcello and Nagy (2004) Audit firm tenure and

AAERs

US audits between

1988 and 2000

Longer tenure is not associated with more AAERs

No

Mansi et al (2004) Audit firm tenure and the

cost of debt financing

US reporting years between 1974 and 1998

Longer tenure is associated with lower cost of debt financing

Therefore, mandatory audit firm rotation may be viewed by the capital markets as unbeneficial

No

Ghosh and Moon (2005) Audit firm tenure and

investor perceptions of earnings quality

US audits between

1990 and 2000

Longer tenure does not reduce investor perceptions of earnings quality

No

Nagy (2005) Forced audit firm change

and audit quality

Arthur Andersen client audits in 2000 and 2001 compared to former Arthur Andersen client audits performed by the Big

N in 2002 and 2003

Discretionary accruals are lower for smaller, ex-Arthur Andersen, clients which provides some support for mandatory audit firm rotation

Yes

Arel et al (2006) Audit firm rotation and

modified audit opinions

An experiment with

105 CPA firm auditors

Mandatory audit firm rotation is associated with more modified audit opinions

Yes

Crabtree et al (2006) Audit firm tenure and

bond ratings for newly issued bonds

New US debt issues between 1990 and 2002

Longer tenure does not decrease bond ratings for newly issued bonds

No

(continued on next page)

Appendix A (continued)

Authors and date Relation examined Sample Primary results Support

for MAFR?

Jennings et al (2006) Audit firm rotation and

the perception of auditor independence

An experiment with

49 National Judicial College judges

Perceptions of auditor independence are enhanced with mandatory audit firm rotation

Yes

Blouin et al (2007) Forced audit firm change

and financial reporting quality

US audits in 2002 of former Arthur Andersen clients

Financial reporting quality did not improve for Arthur Andersen clients that were forced into new [shorter] tenure audits

No

Kealey et al (2007) Prior audit firm tenure

and audit fees paid to successor auditors

US audits in 2002 of former Arthur Andersen clients

The successor audit firm fees are positively related to the number

of years the company was a client of Arthur Andersen This relation is seen as evidence that longer tenure [with Arthur Andersen] is a risk factor priced in the successor audit firm fees

Yes

Chen et al (2008) Audit firm and audit

partner tenure and earnings quality

Taiwan audits between 1990 and 2001

Above and beyond the effects of partner rotation on earnings quality, longer tenure does not reduce earnings quality

No

Jenkins and Velury (2008) Audit firm tenure and

accounting conservatism

US audits between

1980 and 2004

Accounting conservatism is reduced in short-tenure audits

No

Kaplan and Mauldin (2008) Audit firm rotation and

the perception of auditor independence

An experiment with

55 MBA student subjects

Above and beyond partner rotation, mandatory audit firm rotation does not lead

to increased perception of auditor independence

No

Davis et al (2009) Audit firm tenure and

earnings management

US audits between

1988 and 2006

Longer tenure is associated with more earnings management

in the pre-SOX period, but not in the post-SOX period

No

Ruiz-Barbadillo et al (2009) Mandatory audit firm

rotation and going concern opinions

Spanish audits of financially distressed companies between

1991 and 2000

The existence of a mandatory rotation rule does not lead to

an increase in going concern opinions to distressed companies

No

Arel, B., Brody, R., & Pany, K (2006) Findings on the effects of audit firm

rotation on the audit process under varying strengths of corporate

Blouin, J., Grein, B M., & Rountree, B R (2007) An analysis of forced auditor change: The case of former Arthur Andersen clients The Accounting Review, 82(3), 621–650.

Carcello, J V., & Nagy, A L (2004) Audit firm tenure and fraudulent financial reporting Auditing: A Journal of Practice & Theory, 23(2),

Appendix A (continued)

Authors and date Relation examined Sample Primary results Support

for MAFR?

Wang and Tuttle (2009) Audit firm rotation and

auditor negotiation strategies

An experiment with

54 graduate business students

Mandatory audit firm rotation is associated with auditors who display less cooperative negotiation strategies with their clients

Yes

accounting conservatism

US audits between

1980 and 2004

Longer tenure is positively related to conservatism, but only for large companies and strongly monitored companies

For smaller companies and weakly monitored companies, longer tenure is negatively related to

conservatism

Yes

Chi et al (2011) Audit firm tenure and

earnings management

US audits between

2001 and 2008

Longer tenure is negatively associated with abnormal accruals, but positively related to real earnings management

Mixed

Daniels and Booker (2011) Audit firm rotation the

perception of auditor independence and audit quality

An experiment with

207 bank loan officers

Perceptions of auditor independence are enhanced with mandatory audit firm rotation Perceptions

of audit quality are unchanged with mandatory audit firm rotation

Mixed

Kwon et al (2011) Mandatory audit firm

rotation and audit quality

Korean audits from

2000 to 2007

Audit quality was unchanged after mandatory audit firm rotation was

introduced

No

Lowensohn et al (working

paper)

Mandatory audit firm rotation and audit quality

Florida municipal and county audits in 2003

New audits formed by

a rotation policy have higher audit quality as compared to the audit quality of long-standing audits that

do not have a rotation policy

Yes

Carey, P., Geiger, M A., & O’Connell, B O (2008) Costs associated with

going-concern-modified audit opinions: An analysis of the Australian

audit market Abacus, 44(1), 61–81.

Chasen, E (2012, March 21) Volcker backs auditor rotation CFO Journal

(online) Available from http://mobile.blogs.wsj.com/cfo/2012/03/21/

volcker-backs-auditor-rotation/ (2012, April 17).

Chen, C Y., Lin, C J., & Lin, Y C (2008) Audit partner tenure, audit firm

tenure, and discretionary accruals: Does long auditor tenure impair

earnings quality? Contemporary Accounting Research, 25(2), 415–445.

Chi, W., Ling Lei, L., & Mikhail, P (2011) Is enhanced audit quality

associated with greater real earnings management? Accounting

Horizons, 25(2), 315–335.

Cohn, M (2012, March 22) PCAOB hears pros and cons of audit firm

rotation Accounting Today (online) Available from http://

www.accountingtoday.com/news/PCAOB-Hears-Pros-Cons-Audit-Firm-Rotation-62079-1.html?pg=1 (2012, April 17).

Crabtree, A D., Brandon, D M., & Maher, J J (2006) The impact of auditor

tenure on initial bond ratings Advances in Accounting, 22, 97–121.

Daniels, B W., & Booker, Q (2011) The effects of audit firm rotation on

perceived auditor independence and audit quality Research in

Accounting Regulation, 23(1), 78–82.

Davis, L R., Soo, B S., & Trompeter, G M (2009) Auditor tenure and the

ability to meet or beat earnings forecasts Contemporary Accounting

Research, 26(2), 517–548.

DeFond, M L., & Francis, J R (2005) Audit research after Sarbanes–Oxley.

Auditing: A Journal of Practice & Theory, 24(Suppl.), 5–30.

Dopuch, N., King, R R., & Schwartz, R (2001) An experimental

investigation of retention and rotation requirements Journal of

Accounting Research, 39(1), 93–117.

General Accounting Office (GAO) (2003) Required study on the potential

effects of mandatory audit firm rotation Report to the Senate

Committee on Banking, Housing, and Urban Affairs and the House

Committee on Financial Services, November, Washington, DC.

Geiger, M A., & Raghunandan, K (2002) Auditor tenure and audit

reporting failures Auditing: A Journal of Practice & Theory, 21(1),

67–78.

Ghosh, A., & Moon, D (2005) Auditor tenure and perceptions of audit

quality The Accounting Review, 80(2), 585–612.

Glover, S M., Prawitt, D F., & Wood, D A (2006) Publication records of

faculty promoted at the top 75 accounting research programs Issues

in Accounting Education, 21(3), 195–218.

Jenkins, D S., & Velury, U (2008) Does auditor tenure influence the

reporting of conservative earnings? Journal of Accounting & Public

Policy, 27(2), 115–132.

Jennings, M M., Pany, K J., & Reckers, P M J (2006) Strong corporate

governance and audit firm rotation: Effects on judges’ independence

perceptions and litigation judgments Accounting Horizons, 20(3),

253–270.

Johnson, V E., Khurana, I K., & Reynolds, J K (2002) Audit-firm tenure

and the quality of financial reports Contemporary Accounting

Research, 19(4), 637–660.

Kaplan, S E., & Mauldin, E G (2008) Auditor rotation and the appearance

of independence: Evidence from non-professional investors Journal of Accounting & Public Policy, 27(2), 177–192.

Kealey, B T., Lee, H Y., & Stein, M T (2007) The association between audit-firm tenure and audit fees paid to successor auditors: Evidence from Arthur Andersen Auditing: A Journal of Practice & Theory, 26(2), 95–116.

Kleinman, G., Palmon, D., & Anandarajan, A (1998) Auditor independence: A synthesis of theory and empirical research Research in Accounting Regulation, 12(1), 3–42.

Kwon, S Y., Lim, Y., & Simnett, R (2011) Mandatory audit firm rotation and audit quality: Evidence from the Korean audit market SSRN eLibrary.

Larcker, D F., & Rusticus, T O (2010) On the use of instrumental variables

in accounting research Journal of Accounting and Economics, 49, 186–205.

Li, D (2010) Does auditor tenure affect accounting conservatism? Further evidence Journal of Accounting and Public Policy, 29, 226–241 Lowensohn, S H., Reck, J., Casterella, J R., & Lewis, B (2011) An empirical investigation of auditor rotation requirements SSRN eLibrary Mansi, S A., Maxwell, W F., & Miller, D P (2004) Does auditor quality and tenure matter to investors? Evidence from the bond market Journal of Accounting Research, 42(4), 755–793.

Myers, J N., Myers, L A., & Omer, T C (2003) Exploring the term of the auditor–client relationship and the quality of earnings: A case for mandatory auditor rotation? The Accounting Review, 78(3), 779–799 Nagy, A L (2005) Mandatory audit firm turnover, financial reporting quality, and client bargaining power: The case of Arthur Andersen Accounting Horizons, 19(2), 51–68.

Previts, G J (1998) Auditor independence: A perspective on its origins and orientations Research in Accounting Regulation, 12(1), 299–317 Public Company Accounting Oversight Board (PCAOB) (2011) Concept release on auditor independence and audit firm rotation PCAOB Release

No 2011-006, August 16.

Ruiz-Barbadillo, E., Gómez-Aguilar, N., & Carrera, N (2009) Does mandatory audit firm rotation enhance auditor independence? Evidence from Spain Auditing, 28(1), 113–135.

Stefaniak, C M., Robertson, J C., & Houston, R W (2009) The causes and consequences of auditor switching: A review of the literature Journal

of Accounting Literature, 28, 47–121.

Tysiac, K (2012, March 21) PCAOB panelists say mandatory firm rotation could be harmful, helpful Journal of Accountancy (online) Available from http://www.journalofaccountancy.com/Web/20125365.htm

(2012, April 21).

Walker, P L., Lewis, B L., & Casterella, J R (2001) Mandatory auditor rotation: Arguments and current evidence Accounting Enquiries, 10, 209–242.

Wang, K J., & Tuttle, B M (2009) The impact of auditor rotation on auditor–client negotiation Accounting, Organizations & Society, 34(2), 222–243.