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.

• To investigate the factors that contributed to firms' decisions to either retain their Andersen audit team who migrated to another audit firm, or engage a new auditor, after the collapse of Andersen.
• To investigate the effect of forced auditor change on client firms' financial statement quality.
• To examine the costs (switching costs and agency costs) a company faces in switching to a new auditor.

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.

• Companies faced with greater switching costs were more likely to stay with their Andersen audit team.  (Note: Greater switching costs include aggressive accruals, a financial expert on the audit committee, and Andersen industry specialization)
• Companies with greater agency concerns (higher monitoring costs faced by outside shareholders) were more likely to sever ties with their Andersen audit team and hire a new auditor.
• Companies in the highest quintile of performance-matched discretionary accruals that followed Andersen curbed their accrual behavior in the year after Andersen’s collapse, while there was no change for those that did not follow Andersen.
• Overall company governance characteristics were not associated with the decision to retain or switch.
• Overall, the evidence suggests that switching costs likely often outweigh benefits of changing auditors, which explains why we observe infrequent auditor changes for most companies.
• Evidence in the study suggests mandatory rotation may not be effective in improving client firms' overall financial statement quality.

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.

• The authors find that auditor independence and/or reputation concerns are strengthened in lame duck situations because financial reporting quality is higher when a lame duck auditor performs the quality review.
• The authors find that lame duck auditors are more likely among older companies, accelerated filers, companies with a material weakness in internal control, and companies announcing a restatement during the current or prior year.
• The authors find that lame duck auditors are less likely among larger companies, companies audited by a Big N auditor, and companies with higher leverage and higher revenue volatility.
• The authors’ findings verify that the main results of the study are not attributable to systematic differences between lame duck and non-lame duck auditor observations. 
• The authors’ findings suggest that creating more uncertainty regarding the present value of expected future cash flows or increasing potential reputational concerns has the potential to improve assurance quality.

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 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.

• The authors find a stronger association between joint engagement partners and higher audit quality when the partners are from the same, rather than a different, office.
• The authors find that joint engagement partners, compared to single partners, are associated with less accruals (two proxies for audit quality).
• The authors find a small decrease in audit fees for joint engagement partners from different offices compared to single-partner audits. The authors find no difference in audit quality. 

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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.

• When auditors assess the honesty of management representations, auditor rotation increases audit effort and decreases the frequency of low-effort audits paired with aggressive financial reporting, decreasing the likelihood of audit failure.
• When auditors assess the dishonesty of management representations, auditor rotation decreases audit effort and increases low-effort audits paired with aggressive reporting.
• Increasing the level of interpersonal interaction between auditors and managers via informal communication decreases audit effort, but does not interact with the auditor’s mental frame (honest versus dishonest).

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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.

• Audit quality is lowest in first-year audits, improves shortly thereafter, and declines somewhat as tenure becomes very long.
• The probability that a second-, third-, or fourth-year audit receives a high quality rating is, on average, 21 percentage points higher than the probability for a first-year audit, while audit quality for audits where tenure is greater than 13 years is not significantly different from that of a first-year audit.
• Audit effort is significantly higher in first-year audits in spite of discounted fees.
• In audits of SEC registrants, quality increases slowly over the entire tenure range, while audits of private clients exhibit a rapid increase in quality in early years and an equally steep decline in later years.
• Audit partner specialization in the client’s industry is associated with higher audit quality in both the full sample and in first-year audits. For SEC clients, the authors also find that audit quality and audit effort each are positively associated with discretionary accruals (DAs), suggesting that auditors recognize the risks associated with unusual accruals and respond by conducting more effective procedures.
• When ex-Andersen clients are removed from the sample, the authors no longer observe lower audit quality in first year audits.

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