daniels and booker - 2011 - the effects of audit firm rotation on perceived auditor independence and audit quality [mafr]

Findings also indicate that neither the presence of a rotation policy nor the length of the auditor tenure within rotation significantly influences the loan officers’ perceptions of audit q

Research Report

The effects of audit firm rotation on perceived auditor independence

and audit quality

Bobbie W Danielsa,⇑, Quinton Bookerb

a Jackson State University, College of Business, P.O Box 17970, Jackson, MS 39217-06700, United States

b Professor and Chairman, Department of Accounting, Jackson State University, MS, United States

a r t i c l e i n f o

Article history:

Available online 17 April 2011

Keywords:

Audit firms’ independence

Mandatory firm rotation

Audit quality

a b s t r a c t

Our study explores loan officers’ perceptions of auditors’ independence and audit quality under three experimental audit firm rotation scenarios We use a case experiment with

a between-subjects design to determine whether rotation of the audit firm impacts finan-cial statement users’ perceptions of auditor’s independence and quality Findings based on

212 useable responses indicate that loan officers do perceive an increase in independence when the company follows an audit firm rotation policy However, the length of auditor tenure within rotation fails to significantly change loan officers’ perceptions of indepen-dence Findings also indicate that neither the presence of a rotation policy nor the length

of the auditor tenure within rotation significantly influences the loan officers’ perceptions

of audit quality

Published by Elsevier Ltd

Introduction

Several audit failures (e.g., Enron, WorldCom, Sunbeam,

and Waste Management) have prompted regulators to

question whether external auditors are independent

(Commission on Public Trust & Private Enterprise, 2003)

Requiring audit firm rotation by limiting the number of

consecutive years that a particular audit firm can audit a

public company has been discussed as one means of

improving auditor independence (AICPA, 1978; POB,

Act (2002)requires the lead audit partner and audit review

partner (or concurring reviewer) to be rotated every five

years on all public company audits

Audit firm rotation is not a new concept It has been

implemented in several countries such as Israel, Brazil,

Spain and Italy (Catanach & Walker, 1999) Several bills

with provisions dealing with audit firm rotation were

de-bated alongside the Sarbanes-Oxley Act (SOX) as a means

of enhancing auditor independence Nothing was enacted,

but Congress decided further study was needed on the po-tential effects of mandatory rotation on registered public accounting firms In this study, we examine whether loan officers perceive audit firm independence and audit quality

is affected by an audit firm rotation policy

Background and research questions Over the years, practitioners and academicians have de-bated the pros and cons of long-term auditor–client rela-tionships Some believe that the length of time an audit firm maintains a relationship with the client jeopardizes the public perceptions of auditor independence and audit

dimensions: the market-assessed joint probability that auditors will discover a breach in the client’s accounting system; and the likelihood an observed breach will be re-ported DeAngelo reasons that an auditor who has an eco-nomic interest in their client or lacks auditor independence will be less likely to report a discovered breach, thus reduc-ing audit quality (DeAngelo, 1981a)

The AICPA issued a report, ‘‘Statement of Position Regarding Mandatory Rotation of Audit Firms of Publicly

1052-0457/$ - see front matter Published by Elsevier Ltd.

⇑ Corresponding author.

E-mail address: bobbie.w.daniels@jsums.edu (B.W Daniels).

Contents lists available atScienceDirect

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

Held Companies’’ in 1992 The AICPA opposed mandatory

rotation citing that mandatory audit firm rotation was

not in the best interest of the public According to this

study, the AICPA examined 400 cases of audit failures

be-tween 1979 and 1991 and found that audit failures were

about three times more likely when the auditor was

per-forming the first or second audit of that company The

study asserts that requiring firms to change auditors would

increase the risk of audit failures because auditors would

not have sufficient knowledge of the client’s business,

which is important to identify problems early in a business

(AICPA, 1992)

James E Copeland, the CEO of Deloitte and Touche,

speaking before the U.S Senate Committee on Banking,

Housing, and Urban Affairs, indicated that rotation would

increase start-up costs for auditors He points out that

requiring rotation of auditors would mean that institutional

knowledge will be lost and on each new engagement the

auditors will be climbing a steep learning curve (Copeland,

2002) John H Biggs, Chairman and CEO of TIAA-CREF, which

practices mandatory rotation, testified before the U.S

Senate Committee on Banking, Housing and Urban Affairs

about the positive aspects of rotation for companies

According to Biggs, if Enron had been required to rotate its

auditors every five to seven years, they would not have

con-tinued to issue misleading financial information (Biggs,

2002) Furthermore, Biggs noted that rotation would also

reduce low-balling of other non-audit services and

elimi-nates the revolving door phenomenon (Biggs, 2002)

SOX required the General Accounting Office to study the

potential effects of mandatory audit firm rotation on public

companies GAO surveyed and interviewed accounting

firms, chief fiscal officers and audit committee chairs of

the Fortune 1000 publicly-traded companies The majority

of the largest public accounting firms and the Fortune 1000

companies interviewed agreed that the costs associated

with audit firm rotation are likely to exceed the benefits

Many of the participants surveyed indicated that SOX’s

requirements regarding audit partner rotation (using

dif-ferent individuals within an audit firm) and auditor

inde-pendence would achieve the same benefits as audit firm

rotation (using different audit firms) GAO also interviewed

other interested parties (consumer groups, institutional

investors, accountants, etc.) Views of these groups were

consistent with the overall views of other survey

respon-dents interviewed by GAO GAO acknowledges that it will

take several years of experience with the implementation

of SOX before the effectiveness of the act can be fully

as-sessed (GAO, 2003)

Research questions

This study addresses two research questions First, we

address whether periodic rotation of the external audit

firms would affect bank loan officers’ perceptions of

exter-nal auditor independence While this topic has been

stud-ied, the answer remains unclear Numerous researchers

have addressed this topic by using accruals-based

mea-surements, (Myers, Myers, & Omer, 2003), earning

man-agement tools (Ghosh & Moon, 2005), financial reporting

failures (Carcello & Nagy, 2004) and Judges’ perceptions (Jennings, Pany, & Reckers, 2006) Some researchers have argued that audit firm rotation appears to increase the per-ception of auditor independence (Arel, Brody, & Pany, 2005; Brody & Moscove, 1998; Jennings et al., 2006; Kemp, Reckers, & Arrington, 1983; Ramsey, 2001; Winters, 1978; Wolf, Tackett, & Claypool, 1999) However, because there are no regulatory requirement for audit firm rotation and 99% of the fortune 1000 public companies do not have a policy that requires audit firm rotation (GOA, 2003), archi-val data is not available for research in this area Our exper-imental design circumvents the endogeneity problem We

do so by using an experimental design that manipulates (1)

an audit firm rotation policy versus no rotation policy and (2) the effects of tenure within a rotation policy

The profession maintains that auditors must be inde-pendent ‘‘in fact’’ and ‘‘in appearance.’’ While both must

be studied to understand independence, to research inde-pendence ‘‘in fact’’ requires information that is not publicly available Prior researchers (Hill & Booker, 2007; Imhoff, 1978; Knapp, 1985; Lowe, Geiger, & Pany, 1999) have used perception to measure independence in appearance Perception of independence is important as financial statement users rely on auditors to provide an unbiased opinion and to provide a level of confidence about the reli-ability of financial statements

TheCommission on Public Trust & Private Enterprise’s

rotation of auditors as a means of enhancing auditor inde-pendence and building investor confidence The Commis-sion believes that the cost of auditor rotation is less than the costs of crises in investor confidence Accordingly, we develop the following research questions:

RQ1a: Does the rotation of the external audit firm affect the bank loan officers’ perceptions of audit firms’ independence?

RQ1b: What impact does the length of the auditor ten-ure within rotation have on the bank loan officers’ per-ceptions of audit firms’ independence?

RQ2a: Does the rotation of the external audit firm affect the bank loan officers’ perceptions of audit quality? RQ2b: What impact does the length of the auditor ten-ure within rotation have on the bank loan officers’ per-ceptions of audit quality?

Research methods

We use a between-subjects experimental design for this research with three versions of a case The versions of the case are different only as it relates to the rotation policy and length of tenure within the rotation policy This sec-tion provides details on participants, data gathering and variables, and statistical methods

Participants Our population consists of one thousand bank loan offi-cers who were randomly selected from a database of more than 16,000 U.S bank loan officers We randomly assigned the loan officers to one of three versions of the research

instrument We received 207 useable responses,

represent-ing a response rate of 24.07% The 207 responses are evenly

distributes among the three experimental groups Five

respondents who failed the manipulation checks were

re-moved from our analyses The participants are comprised

primarily of executives (77.9% – president or vice

presi-dents) In addition, participants are mostly college

edu-cated with 77% having baccalaureate degrees or higher

Finally, participants have significant experience, with 87%

having over 10 years of banking experience and 67% having

10 years or more of bank lending experience

Data gathering and variables

Each of the three experimental scenarios used involves

a company’s audit firm rotation policy The focus of the

case is a material error in the pre-audit financial

state-ments which management does not want to correct

be-cause of the impact it would have on the firm’s current

year financial statements The audit firm rotation policy

and length of tenure were manipulated The rotation

policy was either: the absence of an audit firm rotation

policy (AFR0 hereafter); a seven-year rotation policy with

one-year auditor tenure (AFR1 hereafter); or a seven-year

rotation policy with six-year auditor tenure (AFR6

hereaf-ter) Loan officers were instructed to read the case

materi-als, render their perceptions of the independence of the

CPA performing the financial statement audit, and render

a decision on the perception of audit quality

The independent variable (audit firm rotation) is the

length of time the CPA firm has been performing the audit

(22 years, seven years, or one year) The first dependent

variable (independence) measures the confidence that

the CPA firm performing the audit is independent The

sec-ond dependent variable (discovery), measures participants’

confidence that the CPA firm will discover the error Both

variables (independence and discovery) are measured on

an eleven-point scale from ‘‘no confidence’’ to ‘‘extreme

confidence.’’ The third dependent variable (report),

mea-sures the perceived likelihood that the auditors would re-port the error These variables are similar to those used

in similar studies (Hill & Booker, 2007; Lowe & Pany, 1995; Lowe et al., 1999)

Statistical methods

We use univariate Analysis of Variance (ANOVA) to compare the means of each of the three groups for our independence question, the Scheffe’s post hoc test to test for differences among all possible combinations of groups, and chi-square analysis to compare proportions of ‘‘Yes’’ and ‘‘No’’ responses to the question concerning whether the audit firm should be allowed to do the audit This dichotomous response question is designed to have the participant make a firm decision based on the perceived-level of independence recorded for the first question Results

The first research question asks whether the presence of

an audit firm rotation policy impacts bank loan officers’ perceptions of auditor’s independence and quality The re-sults are summarized inTable 1 ANOVA results for ques-tion Q1a indicate that the percepques-tions of auditor independence are significantly different among the three groups (F = 4.476, p < 05) These results suggest that respondents’ perceptions are influenced by the presence

of an audit rotation policy

To compare the three groups, we use Scheffe Tests of Multiple Comparisons The rotation groups are perceived

as having a significantly higher level of auditor indepen-dence than the no rotation group (p < 05) The mean re-sponse of AFR0 is 5.65 and mean rere-sponse for AFR1 and AFR6 are 6.70 and 6.77, respectively Thus, a significant dif-ference in perceptions exists between a firm that has a rotation policy and one that does not These results suggest that loan officers are more confident that the external CPA firm is independent when a rotation policy is present The

Table 1

Bank loan officers’ perceptions of auditor independence and quality.

Audit Firm Rotation with one year tenure (AFR1) 6.70 6.30 85.7

Audit Firm Rotation with six year tenure (AFR6) 6.77 6.12 80.5

Significance of overall differences across groups p < 05 p = 584 p = 212 Pairwise Differences c

a Auditor Independence is measured on an 11-point scale anchored at 0 (no confidence) to 10 (extreme confidence) Significance of the overall difference

in means are assessed using ANOVA: F-statistic (2 and 204 degree of freedom) = 4.476.

b

Discovery and report are use as proxy for audit quality based upon DeAngelo’s two-dimensional definition of quality Discovery is measured on an 11-point scaled anchored at 0 (no confidence) to 10 (extreme confidence) Significance of the overall difference in means are assessed using ANOVA: F-statistic (2 and 204 degrees of freedom) = 540 Report represents the percentage of Loan officers who answered yes to the reporting variable Significance of overall differences in the means is assessed using av2

test of proportions; X2 = 3.107.

c

means for AFR1 and AFR6 do not differ significantly Thus,

findings fail to indicate a significant difference in

percep-tion of auditor independence when the firm is performing

the audit in the first year of a rotation policy versus in sixth

year of a rotation policy

The second research question asks whether the

pres-ence of an audit firm rotation policy impacts bank loan

officers’ perceptions of audit quality (Q2a) and the impact,

if any, of the length of the auditor tenure within rotation

(Q2b) Results reveal no significant differences in loan

offi-cers’ confidence that the auditors would discover the

inventory error in the financial statements The statistical

findings suggest that the presence of a rotation policy or

the length of the auditor-tenure within rotation does not

influence the respondents’ perception of the auditors

dis-covering errors in the financial statement Finally, the

rota-tion policy did not significantly affect the beliefs of the loan

officers regarding whether the audit firm would report the

error in its opinion

In summary, the perceptions of loan officers relative to

discovering errors in the financial statement are only

slightly modified when a company employs the same audit

firm as compared to rotating their audit firms

Further-more, the length of the auditor tenure within a rotation

policy fails to significantly change the loan officers’

percep-tions of audit quality

Conclusions, limitation, and future research

Loan officers’ perceive that the presence of an audit firm

rotation policy enhances the perceptions of auditor

inde-pendence, but does not enhance perceptions of audit

qual-ity Further, increasing the length of the auditor tenure

within rotation from a one-year period to a six-year period

fails to significantly impact respondents’ perceptions of

CPA firm independence The findings in this study may

be of interest to board of directors and audit committees

in establishing policies regarding rotating the external

auditors Since rotating appears to enhance perceptions

of auditor independence, publicly traded companies that

have used the same auditor for years should consider

whether they should voluntarily adopt a rotation policy

A key issue that must be addressed in deciding whether

to rotate auditors is whether the benefits (i.e., greater

per-ception of independence) exceed the costs (e.g., possibly

higher fees, spill-over knowledge

The results of this study are limited to the perceptions

of bank loan officers Therefore, the results may not be

gen-eralized to other groups Secondly, our sample selection

was limited to only one group of financial statement users

Perceptions of other users groups must also be considered

A third limitation is the realism of the scenario In actual

situations, loan officers would have had access to more

information Therefore, their decisions might have been

different if additional information had been available A

fourth possible limitation stems from the possibility of

nonresponse bias We did conduct tests for non-response

bias that did not indicate a problem Finally, this study

ap-plies to audit firm rotation in an environment whereas the

board of directors has a policy of systematically changing

auditors every seven years It is possible that the results

would not extend to a regulatory regime of mandatory audit rotation

Future research could explore whether user groups views are differ from loan officers (e.g financial analysts, investors, fund managers, audit committee members,

safeguards to mitigate or eliminate threats to indepen-dence Research is needed regarding the effectiveness of different safeguards in different situations Other scenarios involving various lengths of time for the rotation period could also be explored, such as a 3-year, 5-year or 10-year rotation period

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