Audit Firm Rotation and Audit Quality.pdf

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Accounting Research JournalAudit firm rotation and audit quality: evidence from academic research

David S. Jenkins Thomas E. VermeerArticle in format ion:

To cite this document:David S. Jenkins Thomas E. Vermeer, (2013),"Audit firm rotation and audit quality: evidence from academicresearch", Accounting Research Journal, Vol. 26 Iss 1 pp. 75 - 84Permanent link to this document:http://dx.doi.org/10.1108/ARJ-11-2012-0087

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Audit firm rotation and auditquality: evidence from

academic researchDavid 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 hasexamined audit firm rotation both in the USA and in other countries.

Design/methodology/approach The authors outline the unresolved nature of academic researchon 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 generallyfinding mixed results and more recent studies indicating that audit quality generally goes through twodistinct phases during the auditor-client relationship, the auditor learning and auditor closenessphases.

Originality/value Given the importance of the issue, this article provides an overview of academicresearch that has examined audit firm rotation, discusses why academics have been unable to resolvethis issue, and provides suggestions on how academics and practitioners can work together to enhancethe quality of future research.

KeywordsAccounting research, Auditing, Auditor tenure, Auditor-client relationship,Mandatory auditor rotation

Paper typeLiterature review

IntroductionAudit firm rotation as a means of enhancing auditor independence has been scrutinizedand debated by accounting regulators, practitioners, and academics for decades. Mostrecently, the US Congress strongly considered such a policy in drafting theSarbanes-Oxley Act (SOX), but instead settled in favor of mandating five-year partnerrotation. The issue was formally resurrected again in August 2011, when the US PublicCompany Accounting Oversight Board (PCAOB) issued a concept release to solicitcomments on mandatory audit firm rotation, with the PCAOB particularly interested inaudit 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 diminishthe incentives of auditors to placate management and will provide a needed fresh look(PCAOB, 2011). In contrast, the business community generally believes it carriessignificant increased audit costs, undermines the role of the audit committee, decreasesthe 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 firmrotation for public companies is not new and will continue to be a topic of public debate

The current issue and full text archive of this journal is available at

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Accounting Research Journal

Vol. 26 No. 1, 2013

pp. 75-84

q Emerald Group Publishing Limited

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DOI 10.1108/ARJ-11-2012-0087

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for years to come. In addition, the PCAOBs discussions may trigger statesgovernments within the USA to consider audit firm rotation for nonprofits and publiccompanies may consider voluntary audit firm rotation as a positive signal to thefinancial markets[2]. Given the importance of this issue, this article:

. discusses the regulatory background of audit firm rotation in the USA and othercountries;

. provides an overview of academic research that has examined audit firmrotation;

. discusses why academics have been unable to resolve this issue; and

. provides suggestions on how academics and practitioners can work together toenhance the quality of future research.

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

Regulatory background of audit firm rotation in the USA and othercountriesUSAFor more than 35 years, US regulators have considered a regulatory limitation on auditfirm tenure. In 1977, the US Senate Committee on Government Operations, Chaired bySenator Metcalf, published the Metcalf Report. In this report, the Committee noted thata long association between an audit firm and a client may lead to such a closeidentification of each interest that truly independent action by the audit firm becomesdifficult. The report further noted that:

[. . .] one alternative is a mandatory change of accountants after a given period of time, or afterany 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 AccountantsCommission on Auditors Responsibility, better known as the Cohen Commission,reached a different conclusion regarding audit firm rotation. The commissionrecommended against mandatory audit firm rotation because the:

[. . .] cost of mandatory rotation would be high and the benefits that financial statement usersmight 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 bestposition 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 AmericanInstitute of Certified Public Accountants, American Accounting Association, FinancialExecutives Institute, Institute of Internal Auditors, and National Association ofAccountants, issued the Report of the National Commission on Fraudulent FinancialReporting in 1987. In this report, the commission did not address mandatory audit firmrotation; rather it recommended that audit firms should recognize and control theorganizational 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 indicatedthat the professions requirement for a periodic change in the engagement partner incharge, especially coupled with the requirement for second partner reviews, providesa sufficient opportunity for bringing a fresh viewpoint to the audit without creating the

significant costs and risks associated with changing accounting firms that wereidentified by the Cohen Commission (SEC, 1994).

In late 2001, with the failure of Enron, WorldCom, and Global Crossing, the issue ofmandatory audit firm rotation was once again formally considered by regulators.In fact, the US Congress strongly considered such a policy in drafting the SOX, butrather asked the US General Accounting Office (GAO) to study the potential effects ofmandatory audit firm rotation. The GAO issued its report in 2003 suggesting thatseveral years experience with the implementation of SOX is needed before determiningif additional requirements are necessary to enhance auditor independence and auditquality. In 2011, the PCAOB issued a concept release seeking comments on mandatoryaudit firm rotation, given that sufficient time had passed since the implementation ofSOX 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.

AustraliaBesides the USA, other countries are considering mandatory audit firm rotation.In December 2012, Greg Medcraft, Chairman of the Australian Securities andInvestment Commission, noted that they found a 30 percent increase in the failure ofauditors to detect material misstatements in public company financial statements forthe 18 months ended June 30, 2012. Given this deterioration, Mr Medcraft noted that hewill recommend mandatory audit firm rotation to the Australian Government ifstandards drop further, to strengthen the present requirement that audit partnerschange every seven years (Durkin, 2012).

EuropeSimilar to Australia, the European Union (EU) is also concerned with auditorindependence. Following the EUs 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 independenceis neither assurednor 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 USASince audit firm rotation is generally not required in the USA, academic researchexamining audit firm rotation in the USA has been primarily limited to an environmentof voluntary auditor changes. Further, since companies change auditors ratherinfrequently in the USA, many studies addressing mandatory rotation have examinedwhether 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 directlyexamine mandatory audit firm rotation, Carey and Simnett (2006) suggest that auditortenure studies do examine the fundamental underlying objective of mandatory audit

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firm rotation, i.e. that after a long period of tenure, continuing relationships betweena client and audit firm may impact a firms independence, and time may deterioratea firms ability for critical appraisal. Thus, researchers suggest that the results fromauditor 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 havefocused on either financial statement measures such as material misstatements (Carcelloand Nagy, 2004), discretionary accruals (Johnson et al., 2002; Gul et al., 2007), andrestatements (Myerset al., 2003); or audit reporting failures (Geiger and Raghunandan,2002) (Table I)[3]. In addition to examining proxies for audit quality, researchers havealso examined the effects of audit firm tenure from an investor perspective. Specifically,these studies have examined whether a relationship exists between audit firm tenureand the cost of borrowing (Mansi et al., 2004), earnings response coefficients (Ghosh andMoon, 2005), and equity risk premiums (Booneet al., 2008) (Table II)[4].

Earlier studies on voluntary rotation generally model the relation between auditortenure and audit quality as a linear relation, such that audit quality either strictlyincreases or decreases (or has no relation) over time, and have generally found mixedresults. More recent studies have allowed for the possibility of a nonlinear relation. Forexample, Boone et al. (2008) examine the relation between auditor tenure andclient-specific equity risk premiums and document a nonlinear relation. Specifically,they find that the equity risk premium initially decreases as tenure increases, but forlong tenures the equity risk premium increases with additional years of tenure.Meanwhile, Davis et al. (2009) find a similar nonlinear relation and demonstrate thatclients of short and long tenure auditors are more likely to use discretionary accruals tomeet or beat earnings forecasts relative to clients of medium tenure firms. In a similarvein, Jenkins and Velury (2008) examine the relation between auditor tenure and

reporting conservatism and report similar findings.In general, these nonlinear studies indicate thataudit quality generally goes throughtwo distinct phases during the auditor-client relationship. During the early years referredto as the auditor learningphase, auditors becomemore familiarwith the client and auditquality tends to improve. Then, at some point when the relationship reaches a certainthreshold referred to as the auditor closeness phase, audit quality begins to deteriorateas the auditor presumably becomes more complacent and experiences greater challengesto objectivity and independence. This demonstrated nonlinearity likely explains themixed results found in earlier studies; however these recent findings get us no closerto resolving the mandatory rotation issue as the results indicate thatthere may be merit toboth sides of the argument.

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

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Publication

Auditortenurevariable

Auditqualitymeasure

Academicoperationalization

ofaudit

qualitymeasure

Myerset

al.(2003)

StanleyandDeZoort

(2009)

Auditfirmtenure(numberofconsecutive

yearsthefirmhasretainedauditor)

Accountingrestatements

Correctionofapreviouslyissuedfinancial

statement,usuallybecauseofan

accountingirregularityor

misrepresentationcausedby

anerroror

fraud

GeigerandRaghunandan

(2002)

Naturallogofauditfirmtenure

Auditorreportingfailures

Clientbankruptcywithnopr

iorgoing

concernmodifiedauditopinion

Johnsonet

al.(2002)

Gulet

al.(2007)

Auditfirmtenure

Naturallogofauditfirmtenure

Discretionaryaccruals

Totalaccountingaccrualsles

s

nondiscretionaryaccruals(bu

siness

conditions,suchasgrowthandlengthof

operatingcycle,thatnaturallycreateand

destroyaccruals).

Nondiscretionary

accrualsareestimatedusing

aregression

model

CarcelloandNagy(2004)

Dichotomousvariablesforshort(three

yearsorless)andlong(nineyearsormore)

auditfirmtenure

Materialmisstatement

Companyand/oritsofficerschargedby

theSECwithaviolationofRule10(b)of

the1934SecuritiesExchange

Actinan

AccountingandAuditingEn

forcement

Release

CareyandSimnett(2006)Auditpartnertenureusingdichoto

mous

variablesforshort(twoyearsorless)and

long(morethansevenyears)partn

er

tenure

Going-concernopinions

Abnormalworkingcapitalac

cruals

(AWCA)

Meeting/missingearnings

benchmarks

Likelihoodofissuinggoing-concern

opinionfordistressedcompanies

Differencebetweenrealizeda

ndexpected

workingcapital(basedonwo

rkingcapital

tosalesratio)

Smalllossandsmallearningsdecrease

avoidance

Table I.Audit quality measures

as operationalized inaudit firm tenure studies

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to firms with voluntary auditor changes, suggesting that mandatory audit firmrotation improves audit quality. In contrast, Firth et al. (2012) examine the impact ofboth mandatory and voluntary audit firm rotation under different regulatoryenvironments in China. Using an auditors propensity to issue a modified audit opinionas a proxy for audit quality, Firthet al.(2012) find that mandatory audit firm rotationhas a limited impact on audit quality, with the effect restricted to firms located in lessdeveloped 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 toyear. Using this unique setting, Carey and Simnett (2006) examine the associationbetween audit quality and long audit partner tenure in Australia. The authors finda lower propensity to issue a going concern modified opinion and some evidence of justmeeting or missing earnings benchmarks for long tenure observations; suggesting thataudit quality deteriorates with long partner tenure[7]. Rykenet al.(2007) also examinethe rotation practices before and after the implementation of mandatory rotation of leadand audit review partners in Australia. The authors find that the introduction ofmandatory rules after 2005 significantly reduced the incidence of long partner tenure;with auditors in locations outside Australias three major cities more likely to havelonger audit partner tenure than those located in the major cities. The authors suggestthat Australia should consider the need for reasonable exemptions to mandatory

rotation requirements given the higher costs of partner rotation to smaller firms and tofirms in remote locations. Given that the lead auditor must personally sign the auditreport in Australia, Chapple and Hossain (2011) also examine the Australianexperience with the mandatory audit partner requirements. The authors find that58 percent of Australian companies had to change the lead audit partner because of themandated change after 2005 and this change impacted Big 4 and non-Big 4 audit firmsfairly equally. Overall, similar to studies of firms in the USA, collective evidence frominternational studies on audit firm and partner rotation is inconclusive at best.

Publication Auditor tenure variableInvestor perceptionmeasure

Academic operationalizationof investor perception measure

Mansi et al.

(2004)

Audit firm tenure (number of

consecutive years the firm hasretained auditor)

Cost of borrowing Cost of debt (interest rate on

debt capital) and/or debtquality (debt rating fromratings agencies)

Ghosh andMoon (2005)

Audit firm tenure (number ofconsecutive years the firm hasretained auditor)

Earnings responsecoefficient (ERC)

Estimate of the change in acompanys stock price fromthe information provided in itsearnings announcement

Boone et al.(2008)

Audit firm tenure in bothyears and years2 (nonlinearmodel)

Equity risk premium The excess return that anindividual stock provides overa risk-free rate, with the size ofthe premium positivelyvarying with the risk in aparticular stock

Table II.Investor perceptionmeasures asoperationalized in auditfirm tenure studies

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Future directionGiven the unresolved nature of academic research on audit firm rotation both in the USAand internationally, the logical next step is to examine where to go from here. In order todo 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 largelybeen measured by various characteristics of reported earnings and/or investorperceptions. While necessary to this point because of datalimitations, doing so introducesmeasurement error to the models as a variety of factors, outside of audit quality, can affectearnings characteristics and investor perceptions. Second, while the literature hasidentified important auditor characteristics, such as auditor learning and auditorcloseness which are purported to affect audit quality, a much better understanding ofhow these qualities manifest in audit quality is needed. The complex nature of theauditor-client relationship requires a finer measure to capture these qualities than simplythe number of years an auditor has audited a particular client[8]. Finally, and most likelydue to data and measurement limitations, existing research has focused almostexclusively on evaluating the potential benefits/detriments of audit firm rotation on auditquality. Little to nothing substantive has been done to balance these audit quality effectswith associated costs of switching auditors, which has been the primary argument usedto refute the merits of a policy of mandatory rotation.

We believe the common element that can help solve these weaknesses is increasedinput from practitioners. For example, advanced behavioral studies with moreknowledgeable subjects (i.e. experienced practitioners) could compensate for limitationsregarding observable audit quality[9]. In addition, input from practitioners related to ifand how auditor tenure manifests in auditor characteristics such as auditor learning andauditor closeness could provide better model specifications than simply counting thenumber of consecutive years an auditor has audited a client. Finally, practitioner inputregarding the identification and measurement of costs associated with auditor rotation

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

Summary and conclusionOverall, we feel that existing research and related policy decisions on audit firmrotation have reached an impasse. To create more clarity on this issue and movetoward a policy resolution, future research needs to be enhanced. With that, thepurpose of this paper is to highlight the research to date, stimulate dialogue betweenacademics and practitioners, and elicit more involvement of practitioners to enhancethe quality of future research on audit firm rotation.

Notes1. 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 ofthe issue.

2. This would be consistent with the approach that state governments within the USA havetaken with applying SOX-type provisions to nonprofits.

3. See Table I for a description of the various definitions of audit quality as operationalized inaudit firm tenure studies.

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4. See Table II for a description of the various definitions of investor perception of audit qualityas operationalized in audit firm tenure studies.

5. The Korean Financial Supervisory Commission, equivalent to the SEC in the USA, definesa problematic firm as one with high agency problems (e.g. insufficient separation of

ownership and management), financial problems (e.g. excessive reliance on debt andindustry restructuring), questionable auditor changes, and/or GAAP violations in annualreports.

6. Ruiz-Barbadilloet al.(2009) find that mandatory audit firm rotation has no impact on auditquality in their study of Spanish firms.

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

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

9. Current behavioral research on the issue is scant, with Dopuchet al.(2001) being one notableexception.

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Wyatt, E. (2011), Accounting board to seek comments on rotating auditors, New York Times,August 16.

Further reading

Blouin, J., Grien, B. and Roundtree, B. (2007), An analysis of forced auditor change: the case offormer 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 moreleniently 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 authorDavid S. Jenkins can be contacted at: [email protected]

ARJ26,1

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