lu and sivaramakrishnan - 2009 - mandatory audit firm rotation - fresh look versus poor knowledge

Mandatory audit firm rotation: Fresh look versusTo capture auditor independence and opinion shopping, we modelauditor biases a conservative bias or an aggressive bias and clientfirms’ ince

Mandatory audit firm rotation: Fresh look versus

To capture auditor independence and opinion shopping, we modelauditor biases (a conservative bias or an aggressive bias) and clientfirms’ incentives to engage auditors with desired biases We findthat when firms engage in opinion shopping, MAR improvesinvestment efficiency for some firms but impairs investment effi-ciency for other firms More generally, we contribute to the litera-ture by demonstrating the real effects of auditing on corporateresource allocation decisions

Ó 2009 Elsevier Inc All rights reserved

1 Introduction

External auditors serve a valuable function in capital markets by lending credibility to financialstatements issued by public companies, thereby reducing information risk The sanctity of this auditrole depends crucially on the nature of the auditor’s attestation It has been argued that long-termauditor–client relationships can result in auditors becoming complacent and lax in their attestationroles Lack of auditor independence from the client firm is also a matter of concern One suggestedavenue to address these concerns is to place term limits by enforcing mandatory audit firm rotation(MAR) Indeed, MAR has received much attention in legislative and regulatory circles recently, as

0278-4254/$ - see front matter Ó 2009 Elsevier Inc All rights reserved.

* Corresponding author Tel.: +1 7137430448; fax: +1 7137434828.

E-mail address: tlu4@uh.edu (T Lu).

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J Account Public Policy

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 / j a c c p u b p o l

Sarbanes-Oxley Act to look into its costs and benefits However, there is little by way of systematicanalysis in the literature as to whether MAR is at all desirable in the US corporate environment Inthe paper, we present a theoretical model that evaluates the desirability of MAR relative to the currentregime in which the decision to change an auditor is entirely voluntary.

Opponents of MAR argue that a new auditor will not have the benefit of client-specific knowledge

of a previous auditor (GAO, 2003) This poor knowledge of the new auditor hampers the effectiveness ofthe audit process and can result in a deadweight loss to society.Sunder (2003)goes even a step further

to suggest removing the mandatory audit requirement in the first place, ‘‘leaving each firm to decide if

it wishes to have an audit certificate accompany its reports.” On the other hand, proponents of MARclaim that a new auditor would bring a fresh look to the auditing task (Conference Board, 2003), andthat it is an effective way of ensuring auditor independence and preventing ‘‘opinion shopping.” Thefocus of this paper is to model this classic trade-off between fresh look and poor knowledge to addressthe desirability of MAR in a setting in which auditor independence and opinion shopping are realconcerns

To do so, however, we must first specify a criterion for evaluating the desirability of a regime, MAR

or otherwise We use investment efficiency as the criterion by analyzing the impact of an audit regime

on corporate investment decisions, whose cash flow implications are ultimate interest to ers A regime in which investment decisions come closest to first best investment levels (optimalinvestment levels in the absence of any informational asymmetries and agency problems) would beconsidered desirable

sharehold-In any model of MAR, lack of auditor independence must potentially be an issue in the absence ofMAR The auditor independence standard requires that the auditor ‘‘must be without bias with respect

to the client since otherwise he would lack that impartiality necessary for the dependability of hisfindings, however excellent his technical proficiency may be” (AU Section 220—Independence) Wecapture this aspect in our model by introducing auditors who may be biased in viewpoint (a conser-vative bias or an aggressive bias) There are two ways to introduce such a bias One approach is toexamine a setting in which the bias arises as a result of auditors’ incentives A second approach is

to assume that auditors are predisposed to biases in judgment, leading them to process information

in a way that may or may not favor the client (Bazerman et al., 1997) By choosing between a vative auditor and an aggressive auditor, client firms can potentially align auditor bias with their ownreporting incentives

conser-Both approaches to modeling auditor attestation constitute interesting avenues to pursue In thetext, we pursue the latter approach because it allows us to incorporate auditor bias in a tractable man-ner and focus squarely on our primary objective of examining the desirability of MAR in terms of itsimpact on corporate investment decisions That is, our focus is not so much on the source of auditorbias as it is to examine the consequences of auditor bias InAppendix 2, we introduce auditor incentivesand show how auditor biases are endogenized

Specifically, we assume that auditors can be one of two types: conservative or aggressive (Krishnan,

1994) When faced with uncertainty, conservative auditors tend to err on the side of understatement,while aggressive auditors tend to err on the side of overstatement If a firm desires, say, an aggressiveauditor and the incumbent auditor is aggressive, then the firm can retain the incumbent; otherwise,the firm can shift to a new auditor who is aggressive In other words, we are essentially examining thedemand for auditor bias by clients

We assume that a firm, which has private knowledge of its prospect (i.e., the probability of its ture financial condition), chooses an observable investment level to maximize its expected stock priceconditional on the firm’s audited accounting report, net of the investment cost Under MAR, the firmmust pick a new auditor, but has the discretion to choose between a conservative and an aggressivenew auditor In the absence of MAR (hereafter, the non-MAR regime), the firm has an additional option

fu-of retaining the incumbent auditor

Firms are often known to engage in opinion shopping (Lennox, 2000) Opinion shopping refers to afirm’s incentive to switch auditors to secure a more favorable audit opinion ex post (i.e., after theincumbent auditor proposes an audit opinion) In general, opinion shopping compromises the quality

of external audits Clearly, opinion shopping is a potential issue in the non-MAR regime because tor switches are entirely voluntary in this regime However, even under MAR, the firm can potentially

audi-wait till it privately learns its financial condition and then exercise its discretion in choosing between aconservative and an aggressive new auditor Thus, our model presents us with a unique opportunity toexamine how opinion shopping incentives might affect the desirability of MAR—an issue that has notreceived much attention in the debate over MAR.

In our model, the incumbent auditor has a knowledge advantage over the new auditor in the sensethat the incumbent auditor can detect the true financial condition with a higher probability; equiva-lently, the new auditor suffers from poor knowledge However, to the extent that the chosen new audi-tor is of a different type from the incumbent auditor, the new auditor brings a fresh look to the audittask Using this structure, we examine the equilibrium effects of MAR on companies’ investment deci-sions and auditor choices

We find that, when the incumbent auditor is aggressive, MAR results in a switch to a conservativeauditor more frequently than in the non-MAR regime, and when the incumbent auditor is conserva-tive, MAR results in a switch to an aggressive auditor more frequently than in the non-MAR regime.Thus, if the purpose of imposing MAR is to bring in fresh look, it would clearly be achieved.More importantly, to the extent that opinion shopping is a real concern, we find that it has impor-tant implications for the desirability of MAR from an investment efficiency standpoint To establishthis result, we first ignore opinion shopping and assume that firms switch auditors ex ante, i.e., beforeprivately observing their financial condition In this ex ante auditor choice setting in which opinionshopping is not an issue, we show that MAR always impairs investment efficiency

Next, we introduce opinion shopping by allowing firms to switch auditors ex post, i.e., after vately learning their financial condition In this ex post auditor choice setting, firms that have received

pri-an unfavorable report from the incumbent auditor have a natural incentive to seek a favorably biasedopinion from a new auditor Such an opinion shopping incentive drastically alters the implications ofMAR for investment efficiency In particular, it is no longer the case that MAR always impairs invest-ment efficiency Given an aggressive incumbent auditor, MAR impairs corporate investment efficiencyfor firms with good prospects but improves corporate investment efficiency for firms with bad pros-pects In contrast, given a conservative incumbent auditor, MAR impairs corporate investment effi-ciency for firms with bad prospects but improves corporate investment efficiency for firms withgood prospects To our knowledge, our study is the first to highlight the impact of opinion shopping

on the desirability of MAR

The intuition for the above results is as follows In the ex ante auditor choice setting, the capitalmarket knows that the firm has not yet learned its financial condition, so auditor switching is notviewed negatively by the market Therefore, a firm that desires a switch to improve its investment effi-ciency will do so whether in a MAR regime or in a non-MAR regime; however, a firm that does notwish to switch is forced by MAR to switch, which results in a deterioration of its investment efficiency

In brief, in an ex ante auditor choice setting, MAR impairs investment efficiency for some firms withoutimproving investment efficiency for others

However, in the ex post auditor choice setting, the market knows that the firm privately knows itsfinancial condition at the time of switching, and is therefore cognizant of its motives to switch Theconsequent negative market reaction would prevent some firms—those firms that would otherwiseswitch auditors in the ex ante setting to improve investment efficiency—from switching auditors

On the other hand, MAR forces all firms to switch, and so the market cannot tell which firms are ion shopping and which are not.1Consequently, MAR would enable some firms to improve their invest-ment efficiency by making ‘‘desirable” switches, but in the meantime, MAR would impair other firms’investment efficiency by forcing them to make ‘‘undesirable” switches

opin-In related research,Elitzur and Falk (1996)(hereafter, EF) focus on the effect of MAR on the tor’s planned audit quality and employ a multi-period framework EF find that the level of plannedaudit quality will diminish over time under MAR In contrast, we focus on auditor biases and employ

audi-a one-period fraudi-amework

Gietzmann and Sen (2002)(hereafter, GS) find that MAR should only be imposed in thin marketswhere a few clients dominate the auditor’s client portfolio, whereas we find that the desirability of

1

MAR depends on the client prospect and the auditor bias Our study differs from theirs in importantways First, GS focus exclusively on auditor aggressiveness, whereas we study both aggressive andconservative auditor biases Second, GS concentrate on the auditor’s work/shirk decision while weexamine the client’s investment decision and auditor choice, and the capital market price.

Kornish and Levine (2004)(hereafter, KL) model a contractual setting where the auditor serves twoclients, an audit committee and a manager; we study a market setting, where the client firm choosesits auditor in light of its expected capital market price KL argue that the audit committee can use dis-missal threats to discipline the auditor and therefore MAR is detrimental because it reduces the effec-tiveness of such a threat We find that whether MAR is desirable depends on the client prospect andthe auditor bias

Dopuch et al (2001)study MAR in an experimental setting While they assume exogenous benefits

to the firm from financial reports, we derive them endogenously by incorporating a capital market.They focus on auditor aggressiveness; we study both aggressiveness and conservatism Their experi-mental results show that MAR decreases investment but we show that MAR may either increase ordecrease investment, depending on the client prospect and the auditor bias

The paper proceeds as follows: Section2describes our model In Section3, we investigate the ital market’s pricing of the firm and the corporate investment decision given a particular auditor type

cap-We then analyze the client firm’s auditor choice under both MAR and non-MAR regimes and identifyimplications for the investment decision We do so first in an ex ante case in Section4and then in an

ex post case in Section5 Finally, Section6concludes

2 Model

2.1 Technology and sequence of events

Given our purpose of evaluating the desirability of MAR using investment efficiency as the rion, our model centers on a firm’s investment decision The firm chooses an investment level repre-sented by k The cost of the investment is1k2 The investment yields a return gk at some future point intime if the financial condition (i.e., the state of nature) is good ðgÞ, which occurs with probability k; ityields a return of zero if the financial condition is bad ðbÞ, with probability 1  k The parameter g > 0captures the productivity of the investment in monetary terms in the good state

crite-The firm has private knowledge of its financial prospect, k, and its financial condition (g or b) once it

is realized Once the financial condition is realized, the firm prepares a report subject to an audit Theauditor discovers privately the true financial condition with probability q and approves or disapprovesthe client-proposed report With probability q, the auditor accumulates conclusive evidence about theclient’s financial condition, g or b; with probability 1  q, the auditor accumulates inconclusive evi-dence, denoted by i We call q audit quality The audited accounting report is either G or B, where Gsignifies ‘‘good” and B signifies ‘‘bad.” Conditional on the audited accounting report and other availableinformation, the market prices the firm at m Finally, the return to investment, gk or 0, is realized

As a benchmark, we first consider the case in which the firm can credibly commit to choose itsauditor before it learns the realized financial condition (g or b) We refer to this benchmark as the

ex ante auditor choice setting The following time line presents the sequence of events in this setting:Time line 1:

 Nature determines the realization of firm prospect, k, which is privately learned by the firm

 The firm makes an investment of k units and chooses its auditor

 The firm observes the realized financial condition (state), g or b

 The audited accounting report, G or B, is issued

 The capital market prices the firm at m

 The return to investment, gk or 0, is realized

In practice, however, there is no mechanism by which a firm can credibly commit to choose itsauditor ex ante A more realistic model is one which allows for a tactical auditor switch by the firm,

i.e., when the firm has the discretion to choose its auditor ex post, that is, when the firm can potentiallyengage in opinion shopping However, the ex ante setting allows us to first examine the desirability ofMAR in the absence of opinion shopping, which we then use to evaluate the impact of opinion shop-ping on the desirability of MAR The following time line presents the sequence of events when opinionshopping is present:

Time line 2:

 Nature determines the realization of firm prospect, k, which is privately learned by the firm

 The firm makes an investment of k units

 The firm observes the realized financial condition (state), g or b

 The audited accounting report, G or B, is proposed by the incumbent auditor

 The firm either retains its incumbent auditor or switches to a new auditor

 The capital market prices the firm at m

 The return to investment, gk or 0, is realized

2.2 Preferences

We focus exclusively on the conflict between two generations of shareholders and assume that thefirm is run by a manager who wishes to boost the price of the firm in the capital market Such a man-agerial incentive may come from stock-based compensation contracts This assumption is also inkeeping with other models in accounting and finance that focus on inter-generational shareholderconflicts (see, for example,Dye, 1985; Fishman and Hagerty, 1989).2

The firm chooses an investment of k and an auditor to maximize the price prospective shareholderswill be willing to pay, less the investment cost The prospective shareholders in a competitive capitalmarket will receive the eventual return to investment, less the price they pay for the firm Thus, thesocial welfare is maximized when the return on investment (the eventual return to investment lessthe investment cost) is maximized.3

2.3 Audit function

Given the information asymmetry between the current and prospective shareholders regarding therealized state of nature, auditing plays a crucial role of reducing information risk in support of a trade.The auditor can be one of two types: aggressive ðAÞ or conservative ðCÞ.4Auditor conservatism is awell-understood term in the auditing and accounting literatures An auditor is said to be conservativewhen he or she is more inclined to err toward approving a bad report, B, when faced with uncertaintyregarding the true state (that is, when the auditor accumulated inconclusive evidence, i) On the otherhand, an aggressive auditor is more inclined to err toward approving a good report, G, when faced withthe same uncertainty.5

4

Auditor decisions can be modeled here (see the next footnote); that is, we can model auditors as strategic players We choose

to do so in Appendix 2 to streamline the analysis in the text.

5

We show in Appendix 2 how auditor conservatism/aggressiveness can be endogenized In brief, we show that auditor conservatism/aggressiveness is determined by a trade-off faced by the auditor That trade-off is summarized by a ‘‘fee/liability ratio.” Therefore, outside investors can use this ratio to infer whether the auditor is conservative or aggressive In other words, even though we assume in the text that auditor conservatism/aggressiveness is directly observable, this assumption is innocuous in that

Fig 1illustrates auditor conservatism/aggressiveness and the resultant audited accounting reports.Referring toFig 1, if the report G is approved by a conservative auditor, it is fully informative because

it is revealing of the true state g However, when there is uncertainty, the conservative auditor onlyallows the report B and therefore B is noisy Similarly, if the report B is issued by a firm whose auditor

is aggressive, it is fully informative because it is revealing of the true state b However, when there isuncertainty, the aggressive auditor approves the report G and therefore G is noisy

From the above discussion, we can see that auditor conservatism or auditor aggressiveness is notalways bad: auditor conservatism may produce a type I error while auditor aggressiveness may pro-duce a type II error Under certain conditions, one is better; under other conditions, the other is better.(We are going to identify those conditions in Sections4 and 5.) As shown in Sections4 and 5, becausedifferent firms in different conditions demand for different types of auditors, both conservatism andaggressiveness will stay in equilibrium and neither will disappear or be regulated out

With the introduction of two types of auditors, now we define ‘‘fresh look:”

Definition An auditor switch results in a fresh look when the new auditor type is not the same as theold auditor type

We assume that the incumbent auditor has the advantage of client-specific knowledge over thenew auditor, or equivalently, the new auditor has ‘‘poor knowledge.” We capture this knowledge dif-ference through the audit quality, q On the other hand, an incumbent auditor may not be able to see

‘‘correctly” in her audit process because of her ‘‘coziness” with the client due to her long tenure A newauditor instead is not plagued with this problem and comes with a fresh look which may increase theprobability of detecting the client’s financial condition (state) We can represent these two effects onthe audit quality through qða;bÞ, wherearepresents poor knowledge and b represents fresh look Weassume thatdq

d a<0 anddq

db>0; that is, a poorer knowledge decreases audit quality but a fresher lookincreases audit quality Empirical evidence indicates that the effect of poor knowledge dominatesthe effect of fresh look (see, for example,Myers et al., 2003; Stanley and DeZoort, 2007) Therefore,

state evidenceaudit

G G

G

G B

B

audited accounting reportsgiven givenauditor auditorconservatism aggressiveness

Fig 1 Auditor conservatism and auditor aggressiveness.

6

We thank an anonymous reviewer for this way of modeling the poor knowledge and fresh look effects and for the empirical reference.

7

Under a MAR regime, the incumbent auditor may boost up her audit quality towards the end of her tunure in order to ‘‘clean

up skeletons in her closet.” This is consistent with our assumption that q I > q N We thank an anonymous reviewer for rasing up this

We can characterize an auditor fully by the tuple fT; qjg, where T 2 fC; Ag and j 2 fI; Ng The ing table presents the various auditing scenarios along the poor knowledge and fresh look dimensions:(MAR denotes mandatory audit firm rotation.)

Clearly, in the non-MAR setting, the firm can choose to retain the incumbent auditor, whether servative or aggressive, or hire a new auditor, either conservative or aggressive In the MAR setting, thefirm does not have the option of retaining the incumbent auditor, but it can still choose either a con-servative or an aggressive auditor to be the new auditor

con-3 Investment

We begin our analysis by examining the complete information case in which the firm’s financialprospect, k, is public knowledge Let us first consider the case of an aggressive auditor AsFig 1im-plies, by Bayes’ theorem, the market price conditional on the audited report is given by

Because the firm makes its investment decision based on its private information ðkÞ, the choice of k

is informative to the market in that the market can potentially infer k from k Let bkdenote the market’sinference For a particular level of k, the market infers that the firm prospect is bk, and we use kðbkÞ to

refer to that level of investment that triggers the market’s inference, bk Denote the firm’s expectedpayoff by Vðbk; kÞ when a type k firm pretends its type to be bk by investing kðbkÞ We are interested

in equilibria in which the market correctly infers the true k from the firm’s investment choice k:8

Let VðkÞ  Vðk; kÞ represent the firm’s expected payoff when the firm type is revealed fully throughthe investment policy kðkÞ The firm would implement any feasible fully-revealing schedule kðkÞ onlywhen it is incentive compatible

Definition A fully-revealing investment schedule kðkÞ is incentive compatible if

For now, we will not specify whether the auditor is incumbent or new, but will address this issue atthe end of this section

3.1 The optimal investment given an aggressive auditor

Let us consider the case in which the firm is with an aggressive auditor AsFig 1implies, the ket prices conditional on the audited reports of G and B are given by, respectively

3.2 The optimal investment given a conservative auditor

Refer toFig 1 By Bayes’ theorem, with a conservative auditor, the market prices conditional on theaudited reports of G and B are given by, respectively

ðbkÞ

|fflfflffl{zfflfflffl}cost of investment

As before, we restrict our attention to the set of investment schedules that are fully-revealing andstate the main result with respect to properties of the equilibrium investment schedule with a conser-vative auditor.

Proposition 2 For a firm with a conservative auditor:

(A) The equilibrium investment schedule kðkÞ solves the differential equation:

kfirm To do so, the low type firm must make a large investment because a larger investment plies a more favorable firm prospect in the eyes of the market (that is, kðbkÞ is increasing in bk) How-ever, the low k firm also realizes that it has a lower chance of producing a favorable audited reportthan the high k firm (seeFig 1) Hence, the low k firm might not reap the full benefits from mim-icking but surely would bear the full cost of mimicking Thus, by overinvesting enough, the high kfirm effectively deters the low k firm from mimicking and so reveals its type through k inequilibrium

im-Thus far, we have not distinguished between an incumbent auditor and a new auditor sitions 1 and 2 apply equally to incumbent and new auditors with the use of appropriate auditquality ðqÞ to express (5) and (8)—an incumbent auditor discovers the true realized state withprobability qI and a new auditor does so with probability qN, with qI>qN Specifically, the invest-ment schedules for a firm with an incumbent auditor and for a firm with a new auditor are asfollows:

4 Ex ante auditor choice

In this section, we analyze the benchmark case in which the firm chooses its auditor before therealization of its financial condition (state), g or b (refer to time line 1 in Section2) Recall that inthe non-MAR regime, the firm has the discretion to retain the incumbent auditor, whether conserva-tive or aggressive, or switch to a new auditor, whether conservative or aggressive In contrast, the firmmust switch auditors under MAR, but has the option to hire either a conservative or aggressive auditor

to replace the incumbent auditor Thus, in comparing the two regimes, we have a number of differentcombinations to consider

4.1 Auditor choice given an aggressive incumbent auditor

In a non-MAR regime, given an aggressive incumbent auditor, the firm can choose to keep theaggressive incumbent auditor, or hire either an aggressive or conservative auditor The following prop-osition characterizes the firm’s auditor choice

Proposition 3 (Ex ante auditor choice) In a non-MAR regime, a firm with an aggressive incumbentauditor retains its auditor if k P k and switches to a conservative new auditor if k 6 k, where

equilib-In addition, a new auditor’s poor knowledge ðqN<qIÞ increases the likelihood of misstatement and

so reduces the informativeness of financial reporting, and therefore, other things being equal, poorerknowledge increases overinvestment Therefore, we have the following:

Remark 1

(1) Firms with poorer prospects prefer conservative auditors, whereas firms with better prospectsprefer aggressive auditors

(2) Among the same type of auditors, firms prefer incumbent to new auditors

Conventional wisdom might indicate that good firms seek more reputable auditors and ‘‘more utable” means ‘‘more conservative,” i.e.,Proposition 3andRemark 1might appear counterintuitive

rep-We interpret reputable auditors as those who minimize the likelihood of misstatements A tive auditor may send false alarms (the type I error) while an aggressive auditor may be unduly opti-mistic (the type II error) Therefore, when choosing between a conservative auditor and an aggressiveauditor, the firm must trade off these two errors For a good firm, undue optimism is not a concernbecause that firm’s fundamental is truly good, but a false alarm is damaging For that reason, a goodfirm prefers an aggressive auditor So, indeed, as one might think, good firms seek more reputableauditors, but not in the sense that the chosen auditor is conservative; rather, the auditor is ‘‘reputable”

conserva-in the sense that she mconserva-inimizes the likelihood of misstatements

Thus, asProposition 3demonstrates, with an aggressive incumbent auditor, a firm with a high kwill retain its incumbent auditor because she is aggressive but a firm with a low k will switch to a con-servative auditor

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