The adoption of mandatory partner rotation in many countries suggests that regulators believe that the benefits of rotation outweigh the costs and thus a policy of mandatory rotation enhances audit quality. The results of this study provide initial evidence of the effects of mandatory partner rotation on audit quality. Contrary to regulators’ beliefs, the findings do not support the assumption that audit partner rotation will lead to audit quality increases. One caveat to these findings is whether the findings will generalize to other countries with different regulatory and legal regimes.
Chi, W., H. Huang, Y. Liao, and H. Xie. 2009. Mandatory audit partner rotation, audit quality, and market perception: Evidence from Taiwan. Contemporary Accounting Research 26 (2): 359-391.
Bamber, E.M., and L.S. Bamber. 2009. Discussion of “Mandatory audit partner rotation, audit quality, and market perception: Evidence from Taiwan”. Contemporary Accounting Research 26 (2): 393-402.
The Sarbanes-Oxley Act of 2002 (SOX) reduced the period that an audit partner is allowed to serve a particular client from seven consecutive years (required by the AICPA since the 1970s) to five years. The assumption behind the mandatory rotation requirement is that rotating the audit partner will improve auditor independence and audit quality. Research on audit firm rotation in the U.S. suggests that longer audit firm tenure with a client increases audit quality. Although, as Bamber and Bamber point out, the results of audit firm rotation may be different than audit partner rotation because the costs and benefits are quite different. For example, in rotating audit firms, the new firm brings an entirely new audit team and a new audit methodology. In rotating an audit partner, many factors continue to be the same under the new partner (the team, the overall audit methodology, the firm’s history with the client, etc.). Due to the lack of audit partner data in the U.S., this study utilizes audit partner data from Taiwan to assess the effect of mandatory audit partner rotation on audit quality. More specifically, the authors address two primary issues:
The authors use data for publicly-listed firms in Taiwan from the 2004 Taiwan Economic Journal database. Mandatory audit partner rotation became mandatory for firms listed on the two major stock exchanges in 2004. For the 2004 firms, some companies had partners that were required to rotate off the engagement (firms subject to mandatory rotation in that year) whereas other companies did not have partners required to rotate as they had not been on the engagement long enough yet (a non-rotation sample).
The results of this study suggest that the auditor changes resulting from the demise of Andersen did not result in improved financial reporting quality and transparency for the former Andersen clients that parted ways with their former audit practice. This implies that the mandatory rotation of auditors may not yield an increase in financial statement quality. This result should be of interest to audit regulators and standard setters, as well as practitioners seeking to comment on proposed mandatory rotation regulations.
Additionally, the results indicate that switching costs in non-forced auditor change settings likely outweigh agency benefits of changing auditors in many cases. This result may be of interest to shareholders, managers, and audit committees in their respective roles related to auditor selection.
Blouin, J., B. M. Grein, and B. R. Rountree. 2007. An Analysis of Forced Auditor Change: The Case of Former Arthur Andersen Clients. The Accounting Review 82 (3): 621-650.
The authors use a sample of 407 Andersen clients. The authors classify companies as retaining their Andersen audit team if the audit report in the year after Andersen's collapse indicates the new auditor within a city acquired the Andersen audit practice in that same city. Companies that did not adhere to this were classified as having switched to a different auditor. In performing this analysis, the authors examine “Switching costs” (i.e. Andersen industry expertise, auditor tenure, auditee size, auditee complexity, and discretionary accruals) and “Agency Costs” (i.e. auditee size, auditee complexity and transparency, insider ownership, leverage, presence of a blockholder, and audit committee expertise and independence.
The implementation of a mandatory audit firm rotation in the United States would have large implications within the accounting industry. This study provides the PCAOB and other regulators with relevant information regarding the potential policy. The evidence indicates that the majority of investors would have a negative reaction to a mandatory audit firm rotation. It is possible the investors believe the potential benefits of rotation are outweighed by the costs, direct and indirect.
Reid, Lauren C., and J. V. Carcello. 2017. “Investor Reaction to the Prospect of Mandatory Audit Firm Rotation”. The Accounting Review. 92.1 (2017): 183.
In recent years the PCAOB has considered implementing a mandatory audit firm rotation in order to better align auditors’ interests with investors’ interests. This study examines investor reactions to a mandatory audit firm rotation in the United States. It is important to understand investor reactions because the implementation of such a policy would be enacted for their benefit. Due to the fact that it is still a potential policy, it is difficult to determine how investors will react if the PCAOB moves forward. Broadly, the authors test the overall stock market reaction. However, the primary focus is on whether certain markets react differently based on a company’s auditor characteristics. The characteristics considered were industry specialization, audit firm tenure, Big 4/non-Big 4, and audit quality.
The sample contains 3,688 companies and represents over 75% of the entire market capitalization of U.S. companies. The authors obtained U.S. company returns through CRSP and the prices for the MSCI World Index excluding the U.S. through DataStream. The auditor tenure and fee data were collected through Compustat and Audit Analytics. The authors determined 10 main dates to observe investors’ reactions and how that affected the markets for the following 3 days.
Overall, the authors find a significant negative market reaction to events that increased the likelihood of rotation.
Specifically, the authors find the following:
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These results should be of specific interest to regulators who have proposed rules to increase the accountability of auditors by more clearly aligning their reputations with assurance quality, as well as to regulators who have expressed concerns that pressures associated with future audit fee dependence could influence the extent to which auditors behave independently. This study is not meant to be used to influence discussion surrounding mandatory audit firm rotation, as the study focused on voluntary, not mandatory, terminations of the audit-client relationship.
Cassell, C., L. Myers, T. Seidel, and J. Zhou. 2016. The Effect of Lame Duck Auditors on Management Discretion: An Empirical Analysis. Auditing: A Journal of Practice and Theory 35 (3): 51-73.
This study focuses on the unique situation in which the auditor-client bond is severed for future reporting periods but continues for the current reporting period. The authors label the auditors in this situation “lame duck auditors,” borrowing the expression from the political realm. In the context of politics, lame duck politicians frequently act with greater freedom because they are not concerned about how their actions will affect their chances of re-election. This could mean a politician would vote for measures that are better for his constituents no matter the consequences, or he could more easily succumb to pressures from outside influences like lobbyists. Just like in the political setting, the term “lame duck”” should not necessarily convey a negative connotation; the term simply refers to a situation that could alter an auditor’s responsibilities and incentive structures, which could lead to a change in behavior. The authors believe that financial reporting quality is higher in lame duck situations and completed this study to test that hypothesis.
The authors use data from 2000-2010 and focus their investigation on the effect of lame duck auditors on the quality of the quarterly financial statements. Interim quarterly reporting is the primary focus because it allows the authors to focus on the effect of reputation concerns rather than litigation risk.
Organizational learning and knowledge depreciation play a significant role in a firm’s audit strategy, pricing strategy, budgeting and forecasting. Failing to account for knowledge dissipation and differences in learning across personnel may lead to costly errors in the budgeting process. Furthermore, finding that there is little or no learning among lower-level staff provides empirical support for the concern of the effects of high turnover rates among lower-level staff in public accounting. This suggests that targeting retention at this level might reduce costs, including the costs of continuously having to train new personnel.
Causholli, M. 2016. Evidence of Organizational Learning and Organizational Forgetting from Financial Statement Audits. Auditing: A Journal of Practice and Theory 35 (2): 53-72.
Organizational learning occurs when an organization gains knowledge from the repetition of producing a product or providing a service and uses this knowledge to operate more efficiently and at a lower cost. Organizational forgetting is when this knowledge is lost over time and results in losses in productivity and increases in the cost of production. A good amount of research exists on these topics as they relate to production, but the research on the correlation between these topics and professional services is underserved. Causholli investigates the nature of learning in the production of financial statement audits in this paper. This investigation comes at a good time due to the increasing debate surrounding whether mandatory audit firm rotation should be enforced. In 2013, the U.S. House of Representatives prohibited the PCAOB from mandating audit firm rotation, but in 2014 the European Parliament passed new regulation that requires audit firm rotation after a maximum of ten years. Because of these differing viewpoints, Causholli hopes to shed light on the discussion by showing how audit production costs vary with audit firm tenure.
Two equations were used to provide empirical specifications and test the hypotheses. Engagements were divided into three groups based on the number of years with a client, the short-tenure group, the medium-tenure group, and the long-tenure group. The audit production data are provided by a large international accounting firm and were collected as part of the annual internal quality reviews performed in late spring through early fall 2003.
The results of this study are important to understanding the potential benefits of joint engagement partner audits compared to single-partner audits. The results of this study identify an association between the type of partner audit (joint vs. single) and audit quality and audit fees. As regulators consider the association between joint audits and audit quality, the results of this study suggest there are benefits to joint-partner audits, particularly when the partners are located in the same office. Compared to single-partner audits, joint-partner audits are associated with higher audit quality. Compared to joint audit firms, joint-partner audits appear to provide the same benefits without the increased cost.
Ittonen, K., and P. C. Trønnes. 2015. Benefits and costs of appointing joint audit engagement partners. Auditing: A Journal of Practice & Theory 34 (3): 23-46.
Audits using joint engagement partners versus audits using a single engagement partner may produce significant benefits. The purpose of this study is to examine the relationship between joint engagement partners and audit quality and audit fees. The authors of the study predict that joint audit partners improves audit quality via benefits in knowledge and experience, consultation availability with a joint partner, and reducing client-specific knowledge lost due to partner rotation.
The authors use 1,345 firm-year observations from the NASDAQ OMX Exchanges in Finland and Sweden for the period 2005 to 2009.
In first-year audits, lower audit process quality and higher total audit hours are possible additional costs that should be considered in the ongoing debate on mandatory audit firm rotation. Moreover, study results are consistent with the notion that—even prior to the effective date of the Sarbanes-Oxley Act (SOX)—market and related regulatory forces disciplined auditors of public entities to achieve a high level of audit quality when tenure was long or fees from auditor-provided non-audit services were large. In order to serve the public interest, these considerations should be included in assessments of the economic costs and benefits of restrictions on audit firm tenure and non-audit services.
Furthermore, the results suggest that, in the private-client market, audit process quality declines in the long tenure range and when non-audit fees become large, which may be of interest to standard setters in the private sector (e.g., the Auditing Standards Board and US State Boards of Accountancy).
Bell, T.B., M. Causholli, and W.R. Knechel. 2015. Audit Firm Tenure, Non-Audit Services, and Internal Assessments of Audit Quality. Journal of Accounting Research 53(3):461-509.
This study asks whether audit quality declines when audit firm tenure becomes long or when fees from auditor-provided non-audit services become large. The financial crisis of 2008 reignited a long standing debate on the impact of audit firm tenure and auditor-provided non-audit services on audit quality. Prior literature examining effects of audit firm tenure and non-audit services on audit quality have had to use externally observable proxies for audit quality which are, therefore, indirect measures of audit-related outcomes that may not fully reflect the quality of auditors’ execution of the audit process. However, regulators focus on process-related characteristics of audit quality including (1) the extent and appropriateness of evidence supporting the auditor’s opinion and (2) the degree of correspondence between the auditor’s procedures and auditing standards. Therefore there may be a difference between indirect external proxies for audit quality and audit quality proxies actually used by regulators. This study assesses audit quality using direct assessments of attributes of the audit process made by internal reviewers at a large international audit firm in 265 US audits of publicly and privately held clients. Primary analyses are based on two quality measures developed from the review data: 1) the total number of assessed audit deficiencies across 55 separate audit process activities; and 2) a composite assessment of the overall quality of the audit.
The data set used in this research was obtained from a large international accounting firm by one of the authors who was employed by the firm at the time the data were collected. The author developed a questionnaire to gather information during the reviews on various audit fee, production, and other engagement characteristics. The data were gathered in October 2003.
The results of this study are important for both audit firms and regulators when considering the potential impact of mandatory audit firm rotation. Standard setters appear to increasingly advocate for auditors to utilize a mental frame in which they evaluate management assertions in terms of their level of dishonesty relative to verification their honesty. If this preference is ultimately paired with mandatory audit firm rotation, it could actually have a deleterious effect on audit quality. Conversely, this study finds that audit firm rotation can increase audit quality when auditors frame their mental representations of management’s assertions in terms of verification of their honest representations.
Bowlin, K. O., J. L. Hobson, and M. D. Piercey. 2015. The Effects of Auditor Rotation, Professional Skepticism, and Interactions with Managers on Audit Quality. The Accounting Review 90 (4): 1363-1393.
Regulators argue that audit firm rotation can improve audit quality by reducing the potential for longstanding auditor-client relationships to impair auditor independence. Standard setters have also recently noted that auditors often focus on verifying the honesty of management representations, and have encouraged auditors instead to evaluate them in terms of their potential dishonesty. This study examines whether the effects of auditor rotation on audit quality is dependent upon the mental frame used to evaluate either the honesty or dishonesty of management representations about the financial statements.
Mental frame refers to whether an auditor frames their assessments of management representations in terms of either their potential honesty or their potential dishonesty. Psychology research finds that individuals do not make subjective probability assessments, like the probably that management’s assertions are honest (dishonest), based on normative laws of probability, but rather on the amount of subjective psychological support that comes to mind. When decision makers feel relatively unfamiliar with, and therefore, less competent to evaluate, subjective probabilities these individuals often find it difficult to produce psychological support for the probably of their current assessment frame, making them less likely to choose the action associated with that mental frame.
The authors’ model the auditor-client relationship as a strategic game in which the auditor chooses a level of effort based on their perceived level of honesty within management’s financial statements whereas managers choose a level of honesty in reporting based on their perceived level of effort outlayed by the auditor. The researchers utilized an experimental economics experiment. The participants were undergraduate students who were tasked to repeatedly play a game for money designed to model this strategic interaction between auditors and clients. In the audit firm rotation condition the auditor was paired with a different manager each round. The evidence was gathered prior to October 2012.
This study sheds light on what underlies decision making in the imperative audit committee responsibility of auditor appointment: nuanced interactions and power asymmetry among management, the audit committee, and auditors. The auditors viewed the CFO as the client and tailored the proposal accordingly. The audit committee will not be effective unless both auditors and audit committee members fundamentally change their mindsets about their respective roles in relation to client management. As large public companies employ multiple Big 4 firm, the viability of severing existing relationships to bring in a truly independent auditor mindset through audit firm rotation is questionable.
Fiolleau, K., Hoang, K., Jamal, K., & Sunder, S. 2013. How Do Regulatory Reforms to Enhance Auditor Independence Work in Practice? Contemporary Accounting Research 30 (3): 864-890.
This article presents a study on regulatory reforms that aim to enhance auditor independence work. In order to achieve the right balance between the auditors serving commercial versus professional interests, regulators implemented a set of alternative remedies that include mandatory audit partner rotation and enhanced audit committee responsibilities, expertise and independence. As of September 2013, regulators based in Europe and the U.S. are considering to extend rotation requirement to encompass audit firm rotation rather than partner rotation. In this paper, the authors conduct a field study to investigate how regulatory reforms designed to promote auditor independence (specifically audit committee reforms and proposed audit firm rotation requirements) may actually work in the context of auditor change. This study of auditor change also yields insights into the potential consequences of increasing the frequency of auditor–client courtships through mandatory audit firm rotation, which has recently been proposed by regulators as a way of reinforcing auditor independence. The underlying premise is that audit quality would be enhanced by weakening the economic and relationship bonds between auditors and their clients. The authors investigate how the audit committee interprets and executes its legislative mandate in appointing an independent external auditor.
The authors collected data six months after the company’s RFP process and new auditor appointment. The authors obtained a copy of the company’s RFP document from the CFO, and copies of the bid documents directly from all Big 4 audit firms who bid for this audit. They interviewed the company’s CFO and the chair of the audit committee. The authors interviewed each of the four proposed engagement audit partners for 60-90 minutes.
The lower quality and higher effort associated with first-year audits represent additional costs that should be considered in the ongoing debate on mandatory audit firm rotation. The differential findings for private and public clients suggest that market and related regulatory forces discipline auditors of SEC clients to maintain a high level of audit quality even when tenure is long or NAS fees are high. The findings are important for regulatory policies related to audit firm tenure and auditor-provided NAS. The finding that quality declines in private-client audits as NAS fees increase or tenure becomes long should be of interest to standard setters in the private sector.
Bell, T. B., Causholli, M., & Knechel, W. R. 2015. Audit Firm Tenure, Non-Audit Services, and Internal Assessments of Audit Quality. Journal Of Accounting Research 53 (3): 461-509.
After decades of debate and research, the auditing profession, regulators, and researchers continue to wrestle with two longstanding concerns about perceived threats to auditor independence and audit quality: (1) Social bonding—becoming personally friendly with, or increasingly trusting of, client management, and (2) Economic bonding—becoming financially dependent on multiperiod fees from audits and non-audit services (NAS) provided to the client. Regulators have argued that social bonding from long tenure erodes professional skepticism and induces auditor complacency, while economic bonding from non-audit fees prompts auditor concessions or shirking in response to management’s financial reporting demands. On the other hand, the auditing profession has argued that there is no systemic decline in audit quality as audit firm tenure or fees from NAS increase, and that restrictions on tenure or NAS disrupt auditor learning, constrain the financial and human resources available for audit production, and impede knowledge spillovers.
The authors use data from internal assessments of audit quality in a Big 4 firm to investigate the impact of audit firm tenure and auditor-provided non-audit services (NAS) on audit quality.
The data used in this study consists of audit quality assessments, audit firm tenure, audit and NAS fees, total and staff-level audit labor hours, and other key client and engagement characteristics for 265 U.S. audits conducted by a Big 4 firm for both publicly listed (57%) and privately held (43%) clients. Audit firm personnel collected the data during the annual internal quality reviews performed during late spring through early fall of 2003.