jenkins and vermeer - 2013 - audit firm rotation and audit quality - evidence from academic research [mafr]

Keywords Accounting research, Auditing, Auditor tenure, Auditor-client relationship, Mandatory auditor rotation Paper type Literature review Introduction Audit firm rotation as a means o

Audit firm rotation and audit

quality: evidence from

academic research David S Jenkins and Thomas E Vermeer

Department of Accounting & MIS, University of Delaware,

Newark, Delaware, USA

Abstract

Purpose – The purpose of this paper is to provide a succinct overview of academic research that has

examined audit firm rotation both in the USA and in other countries.

Design/methodology/approach – The authors outline the unresolved nature of academic research

on audit firm rotation, review recent literature, discuss why academics have been unable to resolve this

issue and offer suggestions for improving subsequent research in the area.

Findings – Overall, the collective evidence is inconclusive at best; with earlier studies generally

finding mixed results and more recent studies indicating that audit quality generally goes through two

distinct phases during the auditor-client relationship, the “auditor learning” and “auditor closeness”

phases.

Originality/value – Given the importance of the issue, this article provides an overview of academic

research that has examined audit firm rotation, discusses why academics have been unable to resolve

this issue, and provides suggestions on how academics and practitioners can work together to enhance

the quality of future research.

Keywords Accounting research, Auditing, Auditor tenure, Auditor-client relationship,

Mandatory auditor rotation

Paper type Literature review

Introduction

Audit firm rotation as a means of enhancing auditor independence has been scrutinized

and debated by accounting regulators, practitioners, and academics for decades Most

recently, the US Congress strongly considered such a policy in drafting the

Sarbanes-Oxley Act (SOX), but instead settled in favor of mandating five-year partner

rotation The issue was formally resurrected again in August 2011, when the US Public

Company Accounting Oversight Board (PCAOB) issued a concept release to solicit

comments on mandatory audit firm rotation, with the PCAOB particularly interested in

audit terms of ten years or greater ( JOA, 2011) As suggested in the concept release,

there is much disagreement regarding the viability/merits of audit firm rotation

On one side, investors are generally in favor of a rotation requirement as a “powerful

antidote” to auditor conflicts of interests which they believe will significantly diminish

the incentives of auditors to placate management and will provide a needed fresh look

(PCAOB, 2011) In contrast, the business community generally believes it carries

significant increased audit costs, undermines the role of the audit committee, decreases

the quality of audits, and potentially increases the likelihood of opinion shopping

(AICPA, 2011; IIA, 2012; PCAOB, 2011)[1]

Regardless of the outcome of the US PCAOB concept release process, audit firm

rotation for public companies is not new and will continue to be a topic of public debate

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Accounting Research Journal Vol 26 No 1, 2013

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for years to come In addition, the PCAOB’s discussions may trigger states governments within the USA to consider audit firm rotation for nonprofits and public companies may consider voluntary audit firm rotation as a positive signal to the financial markets[2] Given the importance of this issue, this article:

countries;

rotation;

enhance the quality of future research

This overview should be useful to practitioners as they discuss this issue within their firms, with their clients, and the larger business and investor communities

Regulatory background of audit firm rotation in the USA and other countries

USA For more than 35 years, US regulators have considered a regulatory limitation on audit firm tenure In 1977, the US Senate Committee on Government Operations, Chaired by Senator Metcalf, published the Metcalf Report In this report, the Committee noted that

a long association between an audit firm and a client may lead to such a close identification of each interest that truly independent action by the audit firm becomes difficult The report further noted that:

[ .] one alternative is a mandatory change of accountants after a given period of time, or after any finding by the SEC that the accounting firm failed to exercise independent action to protect investors and the public (Metcalf Report, 1977)

In the following year, the American Institute of Certified Public Accountants’ Commission on Auditor’s Responsibility, better known as the Cohen Commission, reached a different conclusion regarding audit firm rotation The commission recommended against mandatory audit firm rotation because the:

[ .] cost of mandatory rotation would be high and the benefits that financial statement users might gain would be offset by the loss of benefits that resulted from a continuing relationship (Cohen Commission, 1977)

Instead, the Cohen Commission recommended that the audit committee is in the best position to determine when rotation is appropriate

The issue of mandatory audit firm rotation in the USA was fairly dormant until late

2001 In fact, the Treadway Commission, a private-sector initiative of the American Institute of Certified Public Accountants, American Accounting Association, Financial Executives Institute, Institute of Internal Auditors, and National Association of Accountants, issued the Report of the National Commission on Fraudulent Financial Reporting in 1987 In this report, the commission did not address mandatory audit firm rotation; rather it recommended that audit firms should recognize and control the organizational and individual pressures that potentially reduce audit quality Further,

in 1994, the SEC was commissioned by US Congress to study auditor independence

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and provide any recommendations for legislation In this staff report, the SEC indicated

that the profession’s requirement for a periodic change in the engagement partner in

charge, especially coupled with the requirement for second partner reviews, provides

a sufficient opportunity for bringing a fresh viewpoint to the audit without creating the

significant costs and risks associated with changing accounting firms that were

identified by the Cohen Commission (SEC, 1994)

In late 2001, with the failure of Enron, WorldCom, and Global Crossing, the issue of

mandatory audit firm rotation was once again formally considered by regulators

In fact, the US Congress strongly considered such a policy in drafting the SOX, but

rather asked the US General Accounting Office (GAO) to study the potential effects of

mandatory audit firm rotation The GAO issued its report in 2003 suggesting that

several years experience with the implementation of SOX is needed before determining

if additional requirements are necessary to enhance auditor independence and audit

quality In 2011, the PCAOB issued a concept release seeking comments on mandatory

audit firm rotation, given that sufficient time had passed since the implementation of

SOX and several hundred cases involving what they determined to be audit failures

were discovered during annual inspections of the largest audit firms for eight years

Australia

Besides the USA, other countries are considering mandatory audit firm rotation

In December 2012, Greg Medcraft, Chairman of the Australian Securities and

Investment Commission, noted that they found a 30 percent increase in the failure of

auditors to detect material misstatements in public company financial statements for

the 18 months ended June 30, 2012 Given this deterioration, Mr Medcraft noted that he

will recommend mandatory audit firm rotation to the Australian Government if

standards drop further, to strengthen the present requirement that audit partners

change every seven years (Durkin, 2012)

Europe

Similar to Australia, the European Union (EU) is also concerned with auditor

independence Following the EU’s three billion bailout of banks during the credit crises,

Michael Barnier, Internal Markets Commissioner of the European Commission,

suggested that “mandatory audit firm rotation would boost the quality of audit,

shattering the perverse pressure on partners not to lose long-standing clients”

(Orlik, 2011, p 1) Mr Barnier further noted that “auditor independence is neither assured

nor demonstrable, and infrequent firm rotation has deprived audit of its ethos:

professional skepticism” (Orlik, 2011, p 1)

Academic research examining audit firm rotation in the USA

Since audit firm rotation is generally not required in the USA, academic research

examining audit firm rotation in the USA has been primarily limited to an environment

of voluntary auditor changes Further, since companies change auditors rather

infrequently in the USA, many studies addressing mandatory rotation have examined

whether and how the duration of the auditor-client relationship (i.e auditor tenure)

affects the quality of audits Although these auditor tenure studies do not directly

examine mandatory audit firm rotation, Carey and Simnett (2006) suggest that auditor

tenure studies do examine the fundamental underlying objective of mandatory audit

Audit firm rotation

77

firm rotation, i.e that after a long period of tenure, continuing relationships between

a client and audit firm may impact a firm’s independence, and time may deteriorate

a firm’s ability for critical appraisal Thus, researchers suggest that the results from auditor tenure studies can shed light on the efficacy of a policy of mandatory audit firm rotation to increase audit quality

Given that audit quality is generally unobservable from publicly available information, researchers have developed proxies for audit quality These proxies have focused on either financial statement measures such as material misstatements (Carcello and Nagy, 2004), discretionary accruals ( Johnson et al., 2002; Gul et al., 2007), and restatements (Myers et al., 2003); or audit reporting failures (Geiger and Raghunandan, 2002) (Table I)[3] In addition to examining proxies for audit quality, researchers have also examined the effects of audit firm tenure from an investor perspective Specifically, these studies have examined whether a relationship exists between audit firm tenure and the cost of borrowing (Mansi et al., 2004), earnings response coefficients (Ghosh and Moon, 2005), and equity risk premiums (Boone et al., 2008) (Table II)[4]

Earlier studies on voluntary rotation generally model the relation between auditor tenure and audit quality as a linear relation, such that audit quality either strictly increases or decreases (or has no relation) over time, and have generally found mixed results More recent studies have allowed for the possibility of a nonlinear relation For example, Boone et al (2008) examine the relation between auditor tenure and client-specific equity risk premiums and document a nonlinear relation Specifically, they find that the equity risk premium initially decreases as tenure increases, but for long tenures the equity risk premium increases with additional years of tenure Meanwhile, Davis et al (2009) find a similar nonlinear relation and demonstrate that clients of short and long tenure auditors are more likely to use discretionary accruals to meet or beat earnings forecasts relative to clients of medium tenure firms In a similar vein, Jenkins and Velury (2008) examine the relation between auditor tenure and reporting conservatism and report similar findings

In general, these “nonlinear” studies indicate that audit quality generally goes through two distinct phases during the auditor-client relationship During the early years referred

to as the “auditor learning” phase, auditors become more familiar with the client and audit quality tends to improve Then, at some point when the relationship reaches a certain threshold referred to as the “auditor closeness” phase, audit quality begins to deteriorate

as the auditor presumably becomes more complacent and experiences greater challenges

to objectivity and independence This demonstrated nonlinearity likely explains the mixed results found in earlier studies; however these recent findings get us no closer

to resolving the mandatory rotation issue as the results indicate that there may be merit to both sides of the argument

Academic research examining audit firm rotation outside the USA Although academic studies in the USA have been primarily limited to voluntary auditor tenure studies, academic researchers have examined audit firm and partner rotation in other countries, such as Australia, China, Korea, Spain, and Taiwan, where mandatory rotation is required to different extents Kim and Yi (2009) examine the impact of audit firm tenure on audit quality in Korea where mandatory audit firm rotation is required for problematic firms[5] The authors find that firms with mandatory auditor changes report significantly lower discretionary accruals compared

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(AWCA) Meeting/missing

Table I Audit quality measures

as operationalized in audit firm tenure studies

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to firms with voluntary auditor changes, suggesting that mandatory audit firm rotation improves audit quality In contrast, Firth et al (2012) examine the impact of both mandatory and voluntary audit firm rotation under different regulatory environments in China Using an auditor’s propensity to issue a modified audit opinion

as a proxy for audit quality, Firth et al (2012) find that mandatory audit firm rotation has a limited impact on audit quality, with the effect restricted to firms located in less developed regions.[6]

Although Australia currently does not have mandatory audit firm rotation, Australia provides a unique experimental setting for academic researchers because, unlike the USA, Australia requires that the lead auditor personally sign the audit report, hence allowing researchers to track changes in the audit partner from year to year Using this unique setting, Carey and Simnett (2006) examine the association between audit quality and long audit partner tenure in Australia The authors find

a lower propensity to issue a going concern modified opinion and some evidence of just meeting or missing earnings benchmarks for long tenure observations; suggesting that audit quality deteriorates with long partner tenure[7] Ryken et al (2007) also examine the rotation practices before and after the implementation of mandatory rotation of lead and audit review partners in Australia The authors find that the introduction of mandatory rules after 2005 significantly reduced the incidence of long partner tenure; with auditors in locations outside Australia’s three major cities more likely to have longer audit partner tenure than those located in the major cities The authors suggest that Australia should consider the need for reasonable exemptions to mandatory rotation requirements given the higher costs of partner rotation to smaller firms and to firms in remote locations Given that the lead auditor must personally sign the audit report in Australia, Chapple and Hossain (2011) also examine the Australian experience with the mandatory audit partner requirements The authors find that

58 percent of Australian companies had to change the lead audit partner because of the mandated change after 2005 and this change impacted Big 4 and non-Big 4 audit firms fairly equally Overall, similar to studies of firms in the USA, collective evidence from international studies on audit firm and partner rotation is inconclusive at best

Publication Auditor tenure variable

Investor perception measure

Academic operationalization

of investor perception measure

Mansi et al.

(2004)

Audit firm tenure (number of consecutive years the firm has retained auditor)

Cost of borrowing Cost of debt (interest rate on

debt capital) and/or debt quality (debt rating from ratings agencies) Ghosh and

Moon (2005)

Audit firm tenure (number of consecutive years the firm has retained auditor)

Earnings response coefficient (ERC)

Estimate of the change in a company’s stock price from the information provided in its earnings announcement Boone et al.

(2008)

Audit firm tenure in both years and years 2 (nonlinear model)

Equity risk premium The excess return that an

individual stock provides over

a risk-free rate, with the size of the premium positively varying with the risk in a particular stock

Table II.

Investor perception

measures as

operationalized in audit

firm tenure studies

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Future direction

Given the unresolved nature of academic research on audit firm rotation both in the USA

and internationally, the logical next step is to examine where to go from here In order to

do so, it seems prudent to discuss why existing research has been unable to resolve the

issue First, as noted previously, audit quality is not directly observable and has largely

been measured by various characteristics of reported earnings and/or investor

perceptions While necessary to this point because of data limitations, doing so introduces

measurement error to the models as a variety of factors, outside of audit quality, can affect

earnings characteristics and investor perceptions Second, while the literature has

identified important auditor characteristics, such as auditor learning and auditor

closeness which are purported to affect audit quality, a much better understanding of

how these qualities manifest in audit quality is needed The complex nature of the

auditor-client relationship requires a finer measure to capture these qualities than simply

the number of years an auditor has audited a particular client[8] Finally, and most likely

due to data and measurement limitations, existing research has focused almost

exclusively on evaluating the potential benefits/detriments of audit firm rotation on audit

quality Little to nothing substantive has been done to balance these audit quality effects

with associated costs of switching auditors, which has been the primary argument used

to refute the merits of a policy of mandatory rotation

We believe the common element that can help solve these weaknesses is increased

input from practitioners For example, advanced behavioral studies with more

knowledgeable subjects (i.e experienced practitioners) could compensate for limitations

regarding observable audit quality[9] In addition, input from practitioners related to if

and how auditor tenure manifests in auditor characteristics such as auditor learning and

auditor closeness could provide better model specifications than simply counting the

number of consecutive years an auditor has audited a client Finally, practitioner input

regarding the identification and measurement of costs associated with auditor rotation

could help balance current research that is focused on benefits/detriments of rotation on

audit quality

Summary and conclusion

Overall, we feel that existing research and related policy decisions on audit firm

rotation have reached an impasse To create more clarity on this issue and move

toward a policy resolution, future research needs to be enhanced With that, the

purpose of this paper is to highlight the research to date, stimulate dialogue between

academics and practitioners, and elicit more involvement of practitioners to enhance

the quality of future research on audit firm rotation

Notes

1 Interestingly, there are dissenting views even among the members of the PCAOB on

the merits of mandatory rotation (Wyatt, 2011), further illustrating the unsettled nature of

the issue

2 This would be consistent with the approach that state governments within the USA have

taken with applying SOX-type provisions to nonprofits

3 See Table I for a description of the various definitions of audit quality as operationalized in

audit firm tenure studies

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4 See Table II for a description of the various definitions of investor perception of audit quality

as operationalized in audit firm tenure studies

5 The Korean Financial Supervisory Commission, equivalent to the SEC in the USA, defines

a problematic firm as one with high agency problems (e.g insufficient separation of ownership and management), financial problems (e.g excessive reliance on debt and industry restructuring), questionable auditor changes, and/or GAAP violations in annual reports

6 Ruiz-Barbadillo et al (2009) find that mandatory audit firm rotation has no impact on audit quality in their study of Spanish firms

7 Carey and Simnett (2006) find no evidence of an association of long audit tenure with abnormal accruals

8 Francis (2011) presents a framework of the audit process that provides a better understanding of the multiple drivers of audit quality

9 Current behavioral research on the issue is scant, with Dopuch et al (2001) being one notable exception

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Boone, J., Khurana, I and Raman, K (2008), “Audit firm tenure and the equity risk premium”, Journal of Accounting, Auditing, and Finance, Vol 23 No 1, pp 115-140

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September 26

rotation”, PCAOB Release No 2011-006, Public Company Accounting Oversight Board,

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Further reading

Blouin, J., Grien, B and Roundtree, B (2007), “An analysis of forced auditor change: the case of

former Arthur Andersen clients”, The Accounting Review, Vol 82 No 3, pp 621-650

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Cahan, S and Zhang, W (2006), “After Enron: auditor conservatism and ex-Andersen clients”, The Accounting Review, Vol 81 No 1, pp 49-82

Krishnan, J., Raghunandan, K and Yang, J (2007), “Were former Andersen clients treated more leniently than other clients? Evidence from going-concern modified opinions”, Accounting Horizons, Vol 21 No 4, pp 423-435

Nagy, A (2005), “Mandatory audit firm turnover, financial reporting quality, and client bargaining power: the case of Arthur Andersen”, Accounting Horizons, Vol 19, pp 51-68 Corresponding author

David S Jenkins can be contacted at: jenkinsd@udel.edu

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