sanders et al - 2009 - facilitating knowledge transfer during sox-mandated audit

Section 203 of SOX 2002states: It shall be unlawful for a registered public accounting firm to provide audit services to an issuer if the lead or coordinating audit partner having primar

Facilitating knowledge transfer during

SOX-mandated audit partner rotation

a

Dixon Hughes PLLC, 500 Ridgefield Court, Asheville, NC 28806, U.S.A

bCalloway School of Business & Accountancy, Wake Forest University, P.O Box 7285 Reynolda Station, Winston-Salem, NC 27109-7285, U.S.A

1 Section 203: Why it matters now

As implications of Section 203 of the Sarbanes-Oxley

Act of 2002 (SOX) manifest, accounting firms and

their clients are beginning to feel the brunt of mandatory audit partner rotation Section 203 of

SOX (2002)states:

It shall be unlawful for a registered public accounting firm to provide audit services to

an issuer if the lead (or coordinating) audit partner (having primary responsibility for the audit), or the audit partner responsible for reviewing the audit, has performed audit

www.elsevier.com/locate/bushor

KEYWORDS

Knowledge

management;

Sarbanes-Oxley;

Audit teams;

Knowledge transfer

Abstract Audit teams are responsible for the discovery of the true financial state of

a business The ramifications of the quality of these efforts ripple throughout our economy Requirements of Section 203 of the Sarbanes-Oxley Act of 2002 (SOX)–— which mandates rotation of the audit team member who bears primary responsibility for the audit–—began to take effect as recently as 2007-2008 The potential for knowledge loss within the audit team via this mandated rotation comes with great costs and risks for all stakeholders, as audit team members possess perhaps the most intimate knowledge of businesses To aid in the prevention of knowledge loss and the facilitation of knowledge transfer from the outgoing to the incoming partner, we suggest four primary knowledge transfer approaches which may be used together in the post-SOX environment These approaches are: (1) adequate planning of member rotation far in advance of the deadline for each partner; (2) consideration of strategic fit among the incoming partner, the client, the industry, and the team; (3) improved documentation of the outgoing partner’s knowledge to be shared with the incoming partner; and (4) increased interaction among the rotating partners–—outgoing and incoming–—and the client to assist in the sharing of critical, yet difficult to transfer, tacit knowledge

#2009 Kelley School of Business, Indiana University All rights reserved

* Corresponding author.

E-mail addresses: csanders@dixon-hughes.com

(C.B Sanders), stewarmd@wfu.edu (M.D Steward),

bridges@wfu.edu (S Bridges).

0007-6813/$ — see front matter # 2009 Kelley School of Business, Indiana University All rights reserved.

doi: 10.1016/j.bushor.2009.07.004

services for that issuer in each of the 5 previous

fiscal years of that issuer

Audit partner rotation is not something new to the

accounting industry, as lead partners have been

rotating off financial statement audit engagements

for almost 30 years (AICPA, 1978) Prior to passage of

the Sarbanes-Oxley legislation, however, only the

lead partner on a financial statement audit was

required to rotate audit clients This rotation was

required every 7 years with a 5 year ‘‘time out’’

period, or the amount of time in which a partner

may not be involved with that specific engagement

(AICPA, 2004) Firms with fewer than five SEC

registrant clients and fewer than 10 partners were

exempt from this stipulation At the time,

regu-lators believed this represented the best balance

of independence and efficiency In the wake of

early-21st century accounting frauds, however,

regulators increased the requirements with the

addition of Section 203 to law While beefing

up safeguards for maintaining objectivity and

independence was a motivation for Section 203,

an outcome of the rotation is knowledge loss within

the audit team as the partner with primary

respon-sibility for the audit is required to rotate off the

engagement

When SOX was enacted, Section 203 received a

lower priority within firms for several reasons One

reason why attention was not immediately paid to

Section 203 is that many people did not recognize a

drastic change from the pre-Sox environment in

which some partners had already been rotating,

though with significant exceptions The main reason

Section 203 was not given priority of planning within

firms, however, is because accounting firms and

public companies alike were very concerned with

other, more immediate sections of SOX Of the 66

pages of SOX, Section 203 represents a single

para-graph of less than a fourth of a page, and firms had

several years before the requirements took effect

Now, Section 203 has been brought to the forefront

because the compliance timeline, as required by

law, has arrived

Accounting firms now must comply with the

man-dated rotation of Section 203 while simultaneously

producing high-quality audits Audit quality offers

reliable and verifiable information that is free from

bias (Behn, Choi, & Kang, 2008) High-quality audits

result from the ability of auditors to find and report

problems (DeAngelo, 1981), and improve specificity

of data (Wallace, 1980) Central to a high-quality

audit is the knowledge possessed by the partner that

allows detection of inconsistencies and aids in the

volume of judgment decisions which must be made

A challenge presented by Section 203 involves how

firms can best preserve the knowledge of the rotat-ing partner Herein, we address this challenge of knowledge loss by describing procedures for retain-ing knowledge within the engagement team and transferring knowledge from departing to incoming partners

First, we begin by analyzing the knowledge man-agement framework, with a particular focus on the transfer of tacit knowledge Next, a discussion of job rotation as it relates to professional services is presented, followed by a description of the pre- and post-SOX audit environment Finally, we outline and explain each of the four knowledge transfer reme-dies that can be used by accounting firms to reduce knowledge loss resulting from the requirements of Section 203

2 Knowledge management framework

The knowledge management framework consists

of knowledge creation and acquisition, transfer of knowledge, and interpretation and application

of knowledge (Huber, 1991; Szulanski, 2000) Of these elements, the transfer of knowledge has been referred to as ‘‘one of the most difficult aspects of the knowledge management process’’ (Turner & Makhija, 2006, p 201) Knowledge

with-in firms is with-inherently difficult to transfer, with-in part because organizational members do not know who knows what and who needs what particular knowl-edge at any given time Due to the nature of rotation required by SOX Section 203, incoming and outgoing partners can be clearly identified, thus the focus can be placed on the prevention of knowledge loss through effective knowledge transfer

Within the knowledge management framework, knowledge transfer is an attempt to reconstruct involved, intricate, and often ambiguous patterns

of information This rich knowledge possessed by partners is valuable to the firm and to the quality of the audit, yet challenging to transfer because it is nuanced, tacit, and multidimensional Knowledge management research suggests the key to preserva-tion of managerial knowledge in complex organiza-tions lies not in making knowledge systems more effective, but in establishing interactions that are embedded in the processes of the organization (Geisler, 2007) The rotation required by Section

203 disrupts knowledge management routines, and in particular accentuates the potential disrup-tion of knowledge transfer

The value of knowledge of the client and the client’s environment is evident in research examin-ing audit failures Such research has found that

significantly more failures arise from early-stage

client-auditor relationships, when mental models

of knowledge about the client are being formed,

than from those which are more mature (Geiger &

Raghunandan, 2002) Potentially, audit failures

arise from lack of information about, and

under-standing of, the client As regards mandatory

rota-tion of the partner bearing key responsibility for an

audit, as set forth under Section 203, relationships

will necessarily be short-circuited; knowledge

about the client and the client’s environment

accompanies the outgoing partner The loss of

knowledge may be further amplified, given the

uneven distribution of knowledge among audit

team members (Vera-Munoz, Ho, & Chow, 2006)

Knowledge loss can increase the cost of an audit, as

more time is needed, and potentially decrease the

quality of the audit

Knowledge is embedded in the routines

per-formed by an organization (Szulanski & Jensen,

2004) The challenge for the audit team is how best

to retain the intimate knowledge of an outgoing

partner when he or she rotates to another team and

is replaced by an incoming partner While recent

research has developed general knowledge

man-agement strategies for companies across industries

(seeGeisler, 2007) and has focused on other

impor-tant aspects of Sarbanes-Oxley beyond mandated

partner rotation (for recent examples see

Nadler & Kros, 2008; Piotroski & Srinivasan, 2008;

Valenti, 2008), little attention has been devoted

specifically to knowledge transfer approaches

ac-counting firms may use in response to Section 203

Herein, we center specifically on knowledge

transfer strategies relevant to the post-SOX–—

specifically, post-Section 203–—environment This

is central to a post-SOX environment, given the

combination of mandated rotation of a particularly

critical organizational employee and the

impor-tance of the outcomes of audit teams for accounting

firms, their clients, investors, and the economy

Toward the end of effectively and efficiently

facilitating knowledge transfer within audit teams,

we later recommend four remedies that accounting

firms can implement to help decrease the amount of

knowledge loss that occurs While it is inevitable

that some knowledge loss will come to pass

upon the mandated rotation of partners, the

knowledge transfer strategies presented will help

limit this occurrence Because audit team members

transform intellectual inputs into valuable outputs,

it is critical that processes and policies are in

place to facilitate the transfer not only of technical

information related to financial standards and

measures, but also of information related to the

client and the client’s environment

3 Mandated rotation and knowledge loss

Rotation of employees in a working environment is not a new topic Rotation can be observed in many fields and industries regardless of the reasons be-hind it (e.g., employee termination, retirement, general employee turnover) However, rarely is ro-tation mandated

Early research in manufacturing suggested job rotation as a means to reduce fatigue and monotony (seeMiller, Dhaliwal, & Magas, 1973) Job rotation has also been suggested to increase experience working in different roles, to assist in creating managers who are generalists, and to improve ca-reer development via the knowledge acquired through rotation (Campion, Cheraskin, & Stevens,

1994) While experience gained in different roles may be a useful outcome of job rotation, mandated rotation of employees in the professional services industry necessarily entails the costs and risks of knowledge loss

Across industries, there is much lower interest in rotating jobs among executives as compared to non-managerial employees (Campion, Cheraskin,

& Stevens, 1994) An underlying reason for this involves the complexity of jobs assumed by those

in managerial positions, and the additional time which is needed to gain expertise This complexity relates to an audit partner in that the intrinsic specialization of the partner consists of both conscious and subconscious engagement-specific information that is acquired and integrated over time While employee learning theory suggests that knowledge is gained and accumulated from job rotation experiences (Eriksson & Ortega, 2006; Ortega, 2001), research has focused on junior em-ployees who have not accumulated the depth of expertise that more senior employees–—such as auditors–—have

Biggs, Selfridge, and Krupka (1993)suggest the types of knowledge possessed by auditors include financial knowledge (both of financial measures and company finances); event knowledge (actual and normal events, and company operations); and pro-cedural knowledge (recognition, reasoning, and evaluation of problems) This knowledge contains general content relevant across clients, as well as rich client-specific information and awareness Au-dit partners possess an intrinsic specialization that they acquire from their experiences and the rela-tionships that they create with their audit clients This is the case for those employed in the profes-sional services industry To perform a high-quality audit, auditors need a high degree of domain-specific knowledge of both the client and the

client’s environment (Danos, Eichenseher, & Holt,

1989) Partners possess intricate mental schemas of

rich knowledge pertaining to each client, as well

as deep, often non-replicable relationships with

the client which bring forth tacit knowledge

Elements of this specialized knowledge will be lost

when audit partners are mandated to leave a

specific engagement

During a partner’s engagement tenure, he or she

develops client-specific knowledge that is difficult

to transfer to another partner coming on to the

engagement Partners have rich experience with

clients In some cases, the audit partner may have

acquired the client for the accounting firm In other

cases, the audit partner may have worked with a

client in years past in an entry-level position with

the audit team, and later worked up to the partner

level This results in client relationships which may

be decades long Thus, the relational knowledge

held by partners about clients can be vast

This tacit knowledge has been identified as a key

factor that distinguishes top auditors from average

auditors (Tan & Libby, 1997) The intrinsic

speciali-zation of tacit knowledge has been described as

‘‘subconsciously understood and applied, difficult

to articulate, developed from direct experience,

and usually shared through highly interactive

con-versation, storytelling, and shared experience’’

(Zack, 1999, p 46) Tacit knowledge is ‘‘not readily

articulated and resists codification It is more apt

to be lost through employee turnover’’ (Droege &

Hoobler, 2003, p 53) Conversely, explicit

knowl-edge is not ambiguous, can be observed, and is

easily articulated Because of the nature of the

specialized, tacit knowledge that partners possess,

it is both more challenging and important to attempt

to preserve as much as possible before partner

transition occurs

According toParise, Cross, and Davenport (2006),

knowledge loss brought on by high rates of employee

turnover–—voluntary or involuntary–—throughout

in-dustries is not being combated and has reached

crisis proportions Audit partners have a high degree

of knowledge about clients, including knowledge of

‘‘quality of people, processes, and business plans’’

that is ‘‘vital for conducting an efficient and

effec-tive audit’’ (Knechel, 2000, p 706) A survey among

audit firms offers support for this notion: the

esti-mated start-up cost for auditors is at least 15% of all

costs incurred in cases whereby the auditor has

experience in the client’s industry, as compared

to 25% for companies whereby the auditor has no

such experience (Arrunada & Paz-Ares, 1997) It is

this knowledge that is lost during partner rotation if

no measures are in place to ensure its transfer

Before we outline the four remedies to assist

partner knowledge transfer, we first describe the auditor’s environment both pre- and post-SOX to provide a context for the remedies

4 Financial statement audits and the pre-SOX environment

All companies registered with the Securities and Exchange Commission are required, by law, to have their financial statements audited by an indepen-dent public accounting firm This audit is an assess-ment of the fairness of a company’s financial statements, and is performed to ensure that the financial statements are in conformance with gen-erally accepted accounting principles (GAAP) as set

by the Financial Accounting Standards Board, a governing body Audits also include an assessment

of a company’s internal controls (now required by SOX) Financial statement audits provide third par-ties such as investors or creditors with assurance of the fair presentation of a company’s financial per-formance Additionally, non-SEC registrants often times have their financial statements audited for reasons other than regulatory compliance; for ex-ample, many private companies are required by creditors or other third parties to have audited financial statements

An independent public accounting firm is engaged by a company to perform an objective audit of its financial statements to attest that the documents contain no material misstatements Auditors perform procedures to provide reasonable assurance that financial statements are fairly presented; however, auditors do not provide absolute assurance, as this would be cost prohibi-tive These accounting firms are hired with the interests of a company’s shareholders in mind, and aim to understand the true nature of an entity’s circumstances Because the company has

a discretionary role in hiring an accounting firm, though, companies are often referred to as clients

of the accounting firm

Within a public accounting firm, teams are cre-ated to perform the work of these financial state-ment audits, and often serve a large list of clients Referred to as engagement teams, these cohorts vary depending on the size of the accounting firm and the size of the audit client A team may work on several clients at one time or, for very large clients, may work on only one client for an unspecified amount of time The American Institute of Certified Public Accountants (AICPA) requires multiple layers

of review for each audit engagement; as a standard industry practice, there are at least four members

on any given team, often times several more

Table 1 provides examples of the roles of various

members of an audit team

As defined by the SEC, an audit partner is ‘‘a

partner who is a member of the audit engagement

team who has responsibility for decision-making on

significant auditing, accounting, and reporting

mat-ters that affect the financial statements or who

maintains regular contact with management and

the audit committee’’ (SEC, 2003) Audit partners

are considered the highest level of leadership on an

engagement team These partners have strong

cli-ent relationships and the greatest responsibility

in the engagement With these characteristics,

audit partners possess great knowledge about the audit clients with whom they are working Because audit partners have served in their field for several–—on average, 10 to 15–—years, they have gained a tremendous amount of knowledge relating

to both public accounting and their firm

5 A new environment created by SOX

Now, post-SOX, the partner with key responsibility for the audit must rotate every 5 years Although enacted in 2002, the partner rotation rules were not

Table 1 Public accounting firm team positions

Associate Lowest position; works on

portions of engagements as assigned; interaction mainly with client’s middle management

Works some in the office and a majority at client sites; generally works on one client at a time

Zero to up to 3 years experience in accounting; college degree

Senior Associate First level of oversight;

performs most engagements with little supervision;

directs and reviews the work

of associates; interaction mainly with client’s middle management

Works some in the office and a majority at client sites; generally works on one client at a time

Normally a minimum of 2 years up to 6 years of experience; college degree; normally passed the CPA exam

Manager Second level of oversight;

supervises, reviews, and completes engagements;

interaction mainly with client’s top management

Works in the office and

at client sites; generally works on several clients

at a time

Normally a minimum of 5 years up to 9 years of experience; college degree; passed the CPA exam

Senior Manager Normally equivalent to

Manager, with slightly more supervision and review responsibilities; interaction mainly with client’s top management

Works in the office and

at client sites; generally works on several clients

at a time

Normally a minimum of 3 years of experience as a Manager; college degree; passed the CPA exam

Engagement

Partner

High responsibility for engagement; interaction exclusively with top management of client

Works in the office and

at client sites; generally works on several clients

at a time

Normally a minimum of 3 years of experience as a Senior Manager; college degree; passed the CPA exam Lead Partner Ultimately responsible for

engagement; signs off on the engagement; interaction exclusively with top management of client

Works in the office and

at client sites; generally works on more clients than an Engagement Partner

Normally a minimum of 3 years of experience as an Engagement Partner; college degree; passed the CPA exam

Concurring

Partner

Independent reviewer of the work performed by the engagement team;

responsibility for final decisions

Not associated with the work of the engagement team

Roughly equivalent to that of

a Lead Partner

effective until ‘‘the first day of a company’s first

fiscal year beginning after May 6, 2003’’ (SEC, 2003)

This means the rules for each audit engagement can

vary depending on the year end of the client A

majority of audit clients have a calendar year end;

so, mandatory partner rotation rules first came into

play starting with the 2004 year end This indicates

that a 5 year rotation would last from 2004 to 2009,

with partners required to rotate off the engagement

in 2009

The SEC stated, ‘‘Because of the importance of

achieving a fresh look to the independence of the

audit function, we believe that a 5 year time out

period is appropriate’’ (SEC, 2003) Partners were

targeted in the legislation due to their high

deci-sion making ability, strong client relationships,

and primary responsibility for the engagement

Further, the SEC noted that ‘‘certain other

signifi-cant audit partners’’ will be subject to a 7 year

rotation and a 2 year time out period Fixing its

sights on strengthening auditor independence, the

SEC believed this framework would present the

optimal balance between audit quality and audit

costs, while still maintaining the best interests of

the public

6 Keeping knowledge within the team

As accounting firms and their audit clients prepare

for partner rotation, knowledge transfer

ap-proaches are needed to help decrease the costs

and risks associated with knowledge loss Given

the volume of decisions in an audit that involve

the partner’s judgment, the more the partner can

understand about the client and the client’s

envi-ronment, the greater the degree to which he or she

can assess the firm’s true financial condition Next,

we focus on four methods aimed at enhancing

knowledge transfer: adequate planning, strategic

rotation, documentation, and increased

interac-tion Each of the strategies is focused on the

part-ner, and three of the four involve the client in some

aspects of the remedy

6.1 Adequate planning

One of the most obvious and beneficial approaches

toward aiding knowledge transfer in the environment

of mandated rotation is adequate planning Simply

stated, the transition of audit partners must be

planned well in advance PricewaterhouseCoopers

(2003), one of the four largest American public

ac-counting firms, stated in a letter to the SEC on Section

203 that, ‘‘the proposed rotation requirements would

cause the firm to have to rotate 181 partners in

88 countries for one large multi-national client.’’ Another accounting firm estimated that over 250 partners in 80 countries would be subject to these requirements (HSBC, 2003) Such comments suggest how critical planning will be to rotate all required partners

Firms and audit clients should plan the rotation from both a logistical and a knowledge transfer stand-point A firm should decide–—well in advance–— which engagement a partner will rotate on to, and when This will allow the extant partner and the incoming partner, as well as surrounding employ-ees and the client, to be aware of the scheduled rotation With this information in mind, partners can begin to interact with one another Events such

as regular meetings and shadowing opportunities are recommended to help acquaint the new partner with the client and the engagement A degree of tacit knowledge can be learned and shared through practice and observation Additionally, the audit client should be notified of the rotation schedule and, if possible, take part in pre-rotation interactions between partners to help the client better prepare for the transition The goal of these early communi-cations is to have the outgoing partner share with the incoming partner as much information as possi-ble, to reduce risks and maintain or increase audit quality All of these events should occur prior to rotation

From a logistics point of view, rotation may be very costly Some accounting firms have offices with only one partner, requiring the partner to relocate when it is time for rotation Further, accounting firms must bear in mind that, in order to keep an audit client, a firm must have two qualified audit partners and two outside concurring reviews to retain clients longer than 5 years Thus, succession decisions should be made with two considerations in mind First, the incoming partner should ideally possess experience in the client’s industry For ex-ample, an outgoing partner of an engagement team auditing a client in the financial services industry should be replaced by a partner who has at some point, preferably as a partner, worked with clients in that industry As regards many domains, however, there may be only a small number of partners with such industry expertise In some cases, rotation before the mandated time period may not be ap-propriate Thus, a second consideration is selection

of a partner who has worked with a client (or clients)

in the same value-chain or supply-chain For exam-ple, a partner possessing deep experience with a manufacturing client which produces office prod-ucts may–—if a partner with no manufacturing indus-try experience is available for rotation–—be a suitable partner for a client which is a retailer of

office supplies and products We suggest that

indus-try experience does not necessarily trump all other

types of partner backgrounds It may be the

case that the accounting firm perceives a greater

fit with a partner in a related industry that is part

of the client’s supply-chain The key point is

advanced selection of a partner who can enter

the engagement as seamlessly as possible

The transfer of tacit knowledge requires time and

multiple interactions between the outgoing and

incoming partners Rotation planning and

communi-cation of the specifics of the plan–—that is, who will

rotate where and when–—afford opportunities for

partners to begin communication with one another,

which enhances the likelihood of sharing more tacit

knowledge between partners Additionally, change

in the leader of a group (e.g., the senior audit

partner) has the potential to alter the quality of

work (Ballinger & Schoorman, 2007) Therefore,

planning in advance not only for the first rotation

in year 5, but also for the second rotation the

following 5 years, may help to minimize disruption

Vancil (1987) suggests a plan for transition of CEO

success that can be applicable to partner rotation

In this framework, a new future leader is identified

in advance of the departing leader The idea behind

this is to decrease the element of surprise

and confusion associated with the change of

leadership (Ballinger & Schoorman, 2007) Thus,

advance planning allows the firm to brace for the

disruption that is likely to follow The engagement

team and client should be aware of the details of the

upcoming transition, and should go through a

dis-engagement process; this would include

introduc-tions and meetings It is also possible that members

of the engagement team will take on more

respon-sibility before and after the transition occurs, to

ensure the engagement still operates in an effective

and efficient manner If this is the case, this increase

in responsibility should be planned in advance, too

An important aspect of planning relates to

involv-ing the client in this transitional process While SOX

was designed in part to increase the independence of

audit teams, payment for audit services and selection

of auditors continue to be handled by client

organi-zations Thus, the client’s involvement in the

transi-tion process may help maintain confidence in the

accounting firm and retain their services in the

fu-ture Specifically, the client should be notified of the

change and of the incoming partner’s background

Research in key contact employee turnover

suggests that a customer’s relationships with key

employees of a service provider are often stronger

than the customer’s relationship with the firm

overall (Bendapudi & Leone, 2002) Clients that

value these strong relationships with key personnel

tend to have heightened concern about the suit-ability of employees replacing the key contact The acceptability of a replacement is centered on the potential knowledge gap between the current contact and the replacement employee This sug-gests that, upon learning of impending partner rotation, an audit client could be concerned about the acceptability of the new partner and the knowledge loss which may occur In order to address this concern, accounting firms should plan to inform their clients as soon as possible and reassure the client of an adequate replace-ment Additionally, before rotation, the outgoing partner should facilitate early introductions be-tween the incoming partner and the client This introduction offers a transition and an implicit ‘‘seal of approval’’ by the outgoing partner, who likely has the strongest relationship with the client

6.2 Strategic rotation

As alluded to in the discussion of adequate planning, accounting firms should consider a strategic rotation of partners Instead of rotating audit partners between various engagements based simply on who is available and their geographical location, succession decisions should

be made weighing fit of the audit partner to engagements

Rotating partners with consideration of fit involves identifying an element of an engagement that matches, on some level, a potential incoming partner’s experience This consideration of fit should trump attempts to keep the partner with a client until the last month of the rotation timeline Potential similarities may include the size of the client’s firm; the attitude of its management; operations within the client’s firm; the firm’s indus-try; the length of time the client has been in business; and, the length of time the client has been with the accounting firm Some aspects of fit may be far more important than others, depend-ing on the client; often times, the client may actu-ally assist in deciding which variables are most crucial For example, a client may think experience

in its industry is far more valuable than experience with similar-sized client firms

Consideration of fit can enhance and speed up the transfer of tacit knowledge, as mental models of the outgoing and incoming auditors share similarities Common experience on some level between part-ners could come in the form of expertise related to a client’s industry, or to the partners’ prior engage-ments or past work history In announcing rotating partners, the accounting firm may find it beneficial

to highlight these similarities such that partners,

team members, and clients have an immediate

sense of any aspects of their shared experience

Similarities act as a connector by which knowledge

transfer may attach and build

6.3 Documentation

A third approach that an accounting firm may utilize

to aid in knowledge transfer between rotating

part-ners involves documentation of intellectual capital

Throughout a partner’s tenure on a particular

en-gagement, he or she may undertake certain

activi-ties–—such as documentation–—which will ease the

transfer of knowledge during rotation By its very

nature, tacit knowledge is difficult to codify; yet,

because of its high value, companies continue to

invest in innovative software and ongoing efforts to

capture this often experientially-based type of

knowledge In the current litigious environment,

audits have become more rigorous and auditors thus

have even more thorough understanding of the

client Currently, there is a strong trend toward

documenting more aspects of an audit This

in-creased documentation, when carried out with

the goal of enhancing knowledge transfer, can be

advantageous during partner rotation

Parise, Cross, and Davenport (2006)suggest that

‘‘critical knowledge loss is not simply what the

departing employees know about their job tasks,

but also .how they get work done on time’’

(p 31) To assist knowledge transfer from outgoing

to incoming partners, the accounting firm may

ask an outgoing partner to document answers to

questions such as:

 Compared to other clients, are there any policies

or procedures of this particular client that may

shape the audit in some way?

 What are the recurring issues of this client, of

which the incoming partner should be made

aware?

 What processes worked especially well with this

client in the engagement?

 What decision-making norms of the client are

unique, and may influence the transparency of

information in some way?

The partner’s documentation of any issues

idiosyn-cratic to the client may help inform the incoming

partner and offer a background by which the

partner can make assessments of the audit The

questions created by the accounting firm can act as

a guide to help capture this tacit knowledge Significantly, the client should not be involved in this documentation process

It is important to note that this documentation process captures critical, client-specific knowl-edge; however, the information may become lost amongst the vast amounts of documentation re-quired during a financial statement audit Because

of this, it is vital to emphasize that new partners must be allowed time to review all documentation provided by former partners Aside from general audit purposes, the goal of the maintenance of separate documentation is to offer a description

of the meta-process of the audit landscape of the client’s firm which can be shared between partners

6.4 Increased interaction

A beneficial approach that can accompany the doc-umentation process is increased interaction, before rotation, between the outgoing and incoming part-ners and the team The client should be involved in this process as it unfolds In general, Droege and Hoobler (2003) suggest that knowledge can be preserved through the ‘‘promotion of employee interaction, collaboration, and diffusions of non-redundant tacit knowledge’’ (p 51) One way

in which this can be accomplished is through increased partner interaction with the engagement team Droege and Hoobler note that it is ‘‘a worth-while goal .to preserve as much tacit knowledge

as possible during key employees’ tenure’’ (p 55) Typically, audit partners are not extensively involved with the engagement team Increasing this involvement between the partners and the engagement team, particularly at more strategic points during an audit, can help disperse to the engagement team some of the knowledge possessed

by the partner

It has been shown that having a social structure which emphasizes employee interaction can en-hance knowledge transfer, and may aid in decreas-ing the potential loss that can occur durdecreas-ing audit partner rotation (Droege & Hoobler, 2003) Increas-ing the amount of client interaction with the outgo-ing and incomoutgo-ing partners and team can be arranged

to enhance opportunities for the sharing of tacit knowledge

Additionally, before rotation, the outgoing partner–—due to his or her rich relationships within the client’s organization–—can be asked to facilitate interactions between the new partner and the cli-ent Close relationships between an auditor and a client have, in fact, been suggested to facilitate the audit process (Arel, Brody, & Pany, 2005) Such

familiarity creates a sense of reassurance in the eyes

of the client, and the client may therefore become

more willing to share with the auditor vital

infor-mation which may not otherwise be discovered

Interactions among the three stakeholders–—the

outgoing partner, the incoming partner, and

the client–—can act as a ‘‘passing of the baton’’

mechanism, with the edification of the incoming

partner by the outgoing partner

Relational capital is not easily and immediately

transferred However, interactions encouraged by

the outgoing partner may act as a signal to the

client of continuity of the relationship Additionally,

during client/partner interactions, the incoming

partner has an opportunity to build his or her

understanding of the complexities of the firm

In particular, during these interactions, partners

should be encouraged to explore potential changes

which could add complexity to the audit Such

issues include, for example: the presence and/or

change of foreign subsidiaries; the likelihood of

litigation or litigation settlements; the change in

company growth rate; and indicators or concerns

of financial distress Client/partner interactions

centered around matters such as these are designed

to help the incoming partner build a knowledge base

from which to make later judgments about the

client’s financial status

7 The time is now

As mandated by Section 203 of the Sarbanes-Oxley

Act of 2002, accounting firms have recently entered

the timeline to begin required audit partner

rota-tion These audit partners possess an intrinsic

spe-cialization, with rich tacit knowledge gained during

their tenure on a financial statement audit

engage-ment An element of this specialized knowledge will

be lost when audit partners are forced to disconnect

from a specific engagement While the entirety of

SOX was designed with the intention of safeguarding

shareholders from gross negligence of corporate

executives, significant costs and risks are associated

with implementation of the requirements

Share-holders ultimately bear these costs If knowledge

loss from the mandates is not prevented and

man-dated partner rotation effectively managed, these

costs to shareholders may increase substantially,

reducing the benefits of the very law that was

designed for their protection

Herein, we have suggested four approaches that

can be utilized collectively by accounting firms and

their clients to help effectively prepare for partner

rotation, in order to decrease the amount of

knowl-edge that is lost Adequate planning, strategic

rotation, documentation, and increased interaction are strategies aimed at preserving valuable knowl-edge possessed by the lead auditor required by Section 203 to rotate from an engagement team Quality audits are the result of a thorough fact-finding mission of dedicated audit teams The effects of audits are felt by more than just the accounting firm, their clients, and investors; indeed, the interconnected economy relies on the thoroughness of audits Thus, knowledge transfer aimed at maintaining or improving audit quality is paramount

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