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  • The Auditing Section
    An Analysis of Forced Auditor Change: The Case of Former...1
    research summary posted May 7, 2012 by The Auditing Section, tagged 03.0 Auditor Selection and Auditor Changes, 03.01 Auditor Qualifications, 04.0 Independence and Ethics, 04.07 Audit Firm Rotation 
    Title:
    An Analysis of Forced Auditor Change: The Case of Former Arthur Andersen Clients
    Practical Implications:

    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.

    Citation:

    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.

    Keywords:
    auditor selection, auditor change, mandatory auditor rotation, audit quality, earnings quality, Arthur Andersen
    Purpose of the Study:
    • 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.
    Design/Method/ Approach:

    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.

    Findings:
    • 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.
    Category:
    Auditor Selection and Auditor Changes, Independence & Ethics
    Sub-category:
    Auditor Qualifications (e.g. size - industry expertise), Audit Firm Rotation, Audit Firm Rotation
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  • Jennifer M Mueller-Phillips
    Audit Firm Tenure, Non-Audit Services, and Internal...
    research summary posted July 22, 2015 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.03 Non-Audit Services, 04.07 Audit Firm Rotation, 11.0 Audit Quality and Quality Control, 11.07 Attempts to Measure Audit Quality 
    Title:
    Audit Firm Tenure, Non-Audit Services, and Internal Assessments of Audit Quality.
    Practical Implications:

    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.

    Citation:

    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.

    Keywords:
    audit firm tenure, audit quality, non-audit services, independence
    Purpose of the Study:

    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 bondingbecoming personally friendly with, or increasingly trusting of, client management, and (2) Economic bondingbecoming 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.

    Design/Method/ Approach:

    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.

    Findings:
    • 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.
    Category:
    Audit Quality & Quality Control, Independence & Ethics
    Sub-category:
    Attempts to Measure Audit Quality, Audit Firm Rotation, Audit Firm Rotation, Non-audit Services
  • Jennifer M Mueller-Phillips
    Audit Firm Tenure, Non-Audit Services, and Internal...
    research summary posted September 15, 2015 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.03 Non-Audit Services, 04.07 Audit Firm Rotation, 11.0 Audit Quality and Quality Control, 11.08 Proxies for Audit Quality 
    Title:
    Audit Firm Tenure, Non-Audit Services, and Internal Assessments of Audit Quality.
    Practical Implications:

    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 thateven 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).

    Citation:

    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.

    Keywords:
    audit quality, audit firm tenure, non-audit services
    Purpose of the Study:

    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.

    Design/Method/ Approach:

    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.

    Findings:
    • Audit quality is lowest in first-year audits, improves shortly thereafter, and then declines somewhat as audit firm tenure becomes long. The decline in quality in the long-tenure range is attributable to audits of private clients.
    • In public-client audits, quality increases slowly over the entire tenure range and is not significantly higher than in a first-year audit until the longest period where tenure exceeds 13 years.
    • In contrast, quality in private-client audits improves quickly after the first year but declines with very long tenure to the point where it is indistinguishable from audit quality in the first year.
    • Audit quality is not associated with non-audit fees in the full sample but, as above, the public- and private-client subsamples exhibit different patterns of association. The association of audit quality with non-audit fees is positive in audits of public clients and negative in the audits of private clients.
    • For public clients, the probability of a high-quality audit is 7 percentage points higher for clients purchasing non-audit services than for clients not purchasing these services.
    • For private clients, the probability of a high-quality audit of a private client purchasing non-audit services is 18 percentage points lower than for those not purchasing non-audit services.
    Category:
    Audit Quality & Quality Control, Independence & Ethics
    Sub-category:
    Audit Firm Rotation, Audit Firm Rotation, Non-audit Services, Proxies for Audit Quality
  • The Auditing Section
    Audit Partner Tenure and Audit Quality
    research summary posted May 7, 2012 by The Auditing Section, tagged 04.0 Independence and Ethics, 04.07 Audit Firm Rotation, 05.0 Audit Team Composition, 05.03 Partner Rotation, 15.0 International Matters, 15.03 Audit Partner Rotation 
    Title:
    Audit Partner Tenure and Audit Quality
    Practical Implications:

    The results of this study are limited to the debate concerning individual audit partner rotation and do not support the argument for, or negate the prior studies that examine, audit firm rotation.  Combining the results of this study with the prior studies suggests that audit firms develop, over time, client and industry-specific knowledge that increases their ability to provide quality audits, and if quality control procedures within the firm are adequate (such as might be expected at a Big 6 firm), then rotating audit partners periodically helps maintain the auditor’s independence and objectivity while minimizing the loss of client-specific knowledge and rtise.

    Citation:

    Carey, P. and R. Simnett 2006. Audit Partner Tenure and Audit Quality. The Accounting Review 81 (3): 653-676.

    Keywords:
    audit partner tenure; audit quality; qualifications; earnings management
    Purpose of the Study:

    For many years, regulators have expressed concern regarding auditors’ extended associations with particular audit clients (i.e., long auditor tenure) and its potential impact on auditors’ independence and objectivity.  In the U.S., the AICPA Practice Section mandated in the 1970’s that audit partners rotate off their client after a seven year period.  The Sarbanes-Oxley Act of 2002 decreased this period to five years for public company engagements.  Outside the U.S., countries following international accounting standards and the Code of Ethics implemented by the International Federation of Accountants, as well as the United Kingdom and Australia, adopted similar standards by the early 2000’s due to the perceived “familiarity threat” associated with long auditor tenure.  Two of the arguments for mandatory rotation are that long auditor tenure 1) results in personal relationships with the client that could impair, consciously or subconsciously, the auditor’s independence, and 2) weakens the auditor’s ability to critically evaluate the client’s assertions.  However, to date, there is little empirical evidence to support these
    arguments.

    Due to data limitations, previous studies examining auditor tenure tend to focus on tenure of the audit firm as a whole.  Contrary to regulators’ perceptions, those studies tend to find that audit quality actually deteriorates in the early years after a change in the client’s audit firm, which is attributed to the “learning curve” effect, and that higher audit quality is associated with longer audit firm tenure, which is consistent with the audit firm developing more knowledge and familiarity with the client and industry as time progresses.  Based on their actions, regulators appear convinced that the potential benefits associated with auditor rotation are greater than the potential risks.  Therefore, the purpose of this study is to further examine whether long auditor tenure contributes to decreased audit quality in a setting where individual audit partners can be identified for particular audit clients.

    Design/Method/ Approach:

    The authors rely on data for Australian-domiciled companies publicly traded on the Australian Stock Exchange in 1995.  The authors accumulate auditor tenure information through 1997.

    The authors proxy for audit quality using three different measures: 1) the auditor’s propensity to issue a going-concern opinion; 2) the client’s reporting of abnormal working capital accruals; and 3) the extent to which key earnings targets are just beaten or missed.  Using the results of prior studies and the arguments and policies provided by regulators, the authors examine the association between audit quality and three measures of auditor tenure: less than two years, three to seven years, and greater than seven years.

    Findings:
    • For going-concern opinions, the authors find that longer audit partner tenures do decrease the individual auditors’ propensity to issue such an opinion.  Sensitivity analyses for this test suggest that these results are driven by non-Big 6 audit firm partners.
    • The results of this study find no association between abnormal working capital accruals and longer audit partner tenure. 
      These findings are in contrast to a prior study that examines the Taiwanese market and does find some support for an increased association between abnormal accruals (i.e., lower earnings quality) and longer auditor tenures,
    • The results show limited evidence of fewer clients just missing earnings benchmarks (i.e., more clients beating earnings benchmarks) in cases where the audit partner has longer tenure at the client.
    Category:
    Independence & Ethics, Audit Team Composition, International Matters
    Sub-category:
    Audit Firm Rotation, Partner Rotation, Audit Partner Rotation, Audit Firm Rotation
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  • Jennifer M Mueller-Phillips
    Audit Report Lags after Voluntary and Involuntary Auditor...
    research summary posted June 22, 2013 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.07 Audit Firm Rotation, 05.0 Audit Team Composition, 05.03 Partner Rotation 
    Title:
    Audit Report Lags after Voluntary and Involuntary Auditor Changes
    Practical Implications:

    Regulators have long debated mandating auditor rotation. This study quantifies some of the costs of auditor rotation, specifically its impact on audit report lag. The findings lend support to opponents of mandatory rotation, since the first year after rotation requires more audit effort. The study also highlights one benefit that partner-firm familiarity can have (in decreasing audit report lag).

    Citation:

    Tanyi P., K. Raghunandan, and A. Barua. 2010. Audit Report Lags after Voluntary and Involuntary Auditor Changes. Accounting Horizons 24 (4): 671-688.

    Keywords:
    Auditor tenure; auditor rotation; audit partner rotation
    Purpose of the Study:

    Because of recent debate about the costs of auditor rotation, the authors examine how mandatory and voluntary auditor rotation affects audit report lag, or the number of days between the fiscal year end and the audit report date.Prior research examines only voluntary auditor rotation, which might have different effects than the mandatory rotation advocated by regulators.

    Design/Method/ Approach:

    Authors use the demise of Arthur Andersen and firms’ subsequent auditor changes as a setting in which to learn about mandatory auditor rotation.

    Authors compare audit report lags for firms with fiscal yearend of December 31, 2002. Audit report lag is the only publicly observable, quantifiable measure of auditor effort.

    Andersen firms switch from Andersen to another audit firm in fiscal 2002, and control firms (voluntary rotation) switch from a Big5 audit firm in fiscal 2002.

    Authors also examine audit report lags in fiscal 2000.

    Authors also partition Andersen firms into firms that follow their Andersen partner into a new audit firm and those that do not.

    Findings:

    Andersen firms that do not follow their partners into a new audit firm have longer audit report lags than clients of other Big 5 auditors who switched to a new auditor in 2002. The audit report lag increases by 6.5 days (from 58.02 days to 62.57 days).

    Andersen firms that follow their audit partners into a new audit firm have shorter audit report lags (by 4.56 days or 7.8 percent) than Andersen firms that did not follow their audit partners.

    Compared with firms that do not change audit clients, firms with voluntary auditor changes experience only marginally longer audit report lags. Firms with mandatory auditor changes have significantly longer audit report lags.

     

    For more information on this study, please contact K. Raghunandan.

    Category:
    Independence & Ethics, Audit Team Composition
    Sub-category:
    Audit Partner Rotation, Audit Firm Rotation
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  • Jennifer M Mueller-Phillips
    Benefits and Costs of Appointing Joint Audit Engagement...
    research summary posted May 31, 2016 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.07 Audit Firm Rotation, 05.0 Audit Team Composition, 05.03 Partner Rotation, 15.0 International Matters, 15.03 Audit Partner Rotation 
    Title:
    Benefits and Costs of Appointing Joint Audit Engagement Partners
    Practical Implications:

     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.

    Citation:

    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.

    Keywords:
    Joint auditing; engagement partners; audit quality; audit fees
    Purpose of the Study:

    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.

    Design/Method/ Approach:

    The authors use 1,345 firm-year observations from the NASDAQ OMX Exchanges in Finland and Sweden for the period 2005 to 2009.

    Findings:
    • 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. 
    Category:
    Audit Team Composition, Independence & Ethics, International Matters
    Sub-category:
    Audit Firm Rotation, Audit Partner Rotation, Partner Rotation
  • Jennifer M Mueller-Phillips
    Evidence of Organizational Learning and Organizational...
    research summary posted July 18, 2016 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.07 Audit Firm Rotation, 11.0 Audit Quality and Quality Control 
    Title:
    Evidence of Organizational Learning and Organizational Forgetting from Financial Statement Audits
    Practical Implications:

     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.

    Citation:

     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.

    Keywords:
    audit efficiency, organizational learning, and audit production
    Purpose of the Study:

    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.

    Design/Method/ Approach:

    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.

    Findings:
    • The author’s findings show that an increase in audit experience leads to an initial reduction in total labor hours.
    • The author finds that when labor hours are disaggregated, learning effects are not homogenous across different ranks of labor; specifically, learning is significant among higher labor ranks (partners, managers, and in-charge) and is not significant for the lower ranks (staff).
    • The author finds some evidence of knowledge depreciation; specifically, an increase in experience beyond the learning period negatively affects productivity. This leads to an increase in production costs for partners and in-charge, but not for managers.
    • Overall, the author’s findings suggest that learning by doing as well as knowledge depreciation occur in a professional service industry.
    Category:
    Audit Quality & Quality Control, Independence & Ethics
    Sub-category:
    Audit Firm Rotation
  • Jennifer M Mueller-Phillips
    How Do Regulatory Reforms to Enhance Auditor Independence...
    research summary posted July 29, 2015 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.02 Impact of Fees on Decisions by Auditors & Management, 04.07 Audit Firm Rotation, 14.0 Corporate Matters, 14.11 Audit Committee Effectiveness 
    Title:
    How Do Regulatory Reforms to Enhance Auditor Independence Work in Practice?
    Practical Implications:

    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.

    Citation:

    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.

    Keywords:
    audit committees, reforms, auditor independence, audit firm rotation, independence
    Purpose of the Study:

    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 auditorclient 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.

    Design/Method/ Approach:

    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.

    Findings:
    • Management controlled access to documents and people, and played a powerful role in making the auditor appointment decision.
    • Management engaged the audit firm that offered the least senior level expertise and the lowest fee.
    • The audit committee adopted management’s priorities in encouraging prospective auditors to demonstrate responsiveness to management.
    • Prospective auditors were reticent to probe the client for information that would have helped them identify risks before accepting the engagement.
    • The auditors were focused on winning the client and were willing to cut fees, move partners to the client’s head office city, and curtail quality control.
    • If management, with private information and interests, continues to have substantial influence over hiring the auditor, then regulatory reforms for audit firm rotation and/or audit committee empowerment are likely to be ineffective.
    • Auditor change puts pressure on audit fees, and requires auditors to demonstrate commitment and responsiveness to the management of both prospective clients and current ones used as referees.
    • Instead of strengthening independence and providing a fresh auditor perspective, the authors find that the auditor change process is dominated by management and is characterized by gestures from prospective auditors to win client favor during the courtship, potentially rendering proposed audit firm rotation ineffective.
    Category:
    Corporate Matters, Independence & Ethics
    Sub-category:
    Audit Committee Effectiveness, Audit Firm Rotation, Audit Firm Rotation, Impact of Fees on Decisions by Auditors & Management
  • Jennifer M Mueller-Phillips
    Investor Reaction to the Prospect of Mandatory Audit Firm...
    research summary posted June 26, 2017 by Jennifer M Mueller-Phillips, tagged 01.06 Impact of PCAOB, 04.07 Audit Firm Rotation 
    Title:
    Investor Reaction to the Prospect of Mandatory Audit Firm Rotation
    Practical Implications:

    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.

    Citation:

    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.

    Keywords:
    mandatory audit firm rotation; event study; PCAOB; investor perception
    Purpose of the Study:

    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.

    Design/Method/ Approach:

    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. 

    Findings:

    Overall, the authors find a significant negative market reaction to events that increased the likelihood of rotation.

    Specifically, the authors find the following:

    • Companies that were audited by Big 4 firms were significantly more likely to have a negative reaction on dates that increased the likelihood of rotation.
    • Similarly, companies that were audited by an industry-expert were significantly more likely to have a negative reaction on dates that increased the likelihood of rotation.
    • Companies with a lower-audit quality experienced a negative market reaction on dates that decreased the likelihood of rotation.
    Category:
    Independence & Ethics, Standard Setting
    Sub-category:
    Audit Firm Rotation, Impact of PCAOB
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  • The Auditing Section
    Mandatory Audit Partner Rotation, Audit Quality, and Market...6
    research summary posted May 7, 2012 by The Auditing Section, tagged 04.0 Independence and Ethics, 04.07 Audit Firm Rotation, 15.0 International Matters, 15.03 Audit Partner Rotation 
    Title:
    Mandatory Audit Partner Rotation, Audit Quality, and Market Perception: Evidence from Taiwan and Discussion of “Mandatory Audit Partner Rotation, Audit Quality, and Market Perception: Evidence from Taiwan”
    Practical Implications:

    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.

    Citation:

    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.

    Keywords:
    audit quality; audit partner rotation
    Purpose of the Study:

    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 examine whether a sample of firms subject to mandatory rotation have higher audit quality as compared to three benchmarks: 1) a sample of firms not subject to mandatory rotation, 2) the mandatory sample in the year prior to adoption, and 3) a sample of firms with voluntary audit partner rotation.
    • The authors examine whether investors perceive higher audit quality for the firms subject to the mandatory rotation requirements relative to the three benchmark samples mentioned above.
    Design/Method/ Approach:

    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). 

    Findings:
    • Audit quality is not significantly different when comparing the sample of Taiwan firms subject to mandatory rotation in 2004 to the sample of Taiwan firms not subject to mandatory rotation in 2004.  They also find no significant difference in audit quality when comparing the sample of Taiwan firms subject to mandatory rotation in 2004 to the sample of Taiwan firms whose audit partner voluntarily rotated in years before 2003.  
    • The audit quality provided by new partners for Taiwan firms subject to mandatory rotation in 2004 is lower than the audit quality of those same Taiwan firms one year earlier, when the audit was led by the prior partner.
    • The authors find that perceived audit quality is not significantly different when comparing the sample of Taiwan firms subject to mandatory rotation in 2004 to the sample of Taiwan firms not subject to mandatory rotation in 2004.  They also find no difference in perceived audit quality when comparing the sample of Taiwan firms subject to mandatory rotation in 2004 to the sample of those same Taiwan firms one year earlier.  They find that perceived audit quality is significantly higher for firms subject to mandatory rotation in 2004 compared to firms where audit partners voluntarily rotated prior to 2003. 
    Category:
    Independence & Ethics, International Matters
    Sub-category:
    Audit Firm Rotation, Audit Partner Rotation, Audit Firm Rotation
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