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  • The Auditing Section
    The Impact of Auditor Rotation on Auditor-client Negotiation1
    research summary posted May 4, 2012 by The Auditing Section, tagged 04.0 Independence and Ethics, 09.0 Auditor Judgment, 09.10 Prior Dispositions/Biases/Auditor state of mind, 10.0 Engagement Management, 10.04 Interactions with Client Management, 15.04 Audit Firm Rotation 
    Title:
    The Impact of Auditor Rotation on Auditor-client Negotiation
    Practical Implications:

    The study investigates how mandatory audit firm rotation may affect the process of auditor-client negotiations that produce financial statements observed by the public.  Standard setters should be cognizant of the possible implications of mandating rotation.  Mandatory rotation will likely change the auditors’ and clients’ incentives and auditors and clients will likely change their negotiation strategies.  This may result in less cooperation between auditors and clients and in fewer negotiations that end to the satisfaction of both parties (not only in the final audit year prior to rotation but also in non-final years).

    Citation:

    Wang, K. J. and B. M. Tuttle. 2009. The Impact of Auditor Rotation on Auditor-client Negotiation. Accounting, Organizations, and Society 34 (2): 222-243.

    Keywords:
    Auditor rotation, auditor independence, auditor-client negotiation
    Purpose of the Study:

    This study is motivated by a demand for research on the potential effects of requiring mandatory rotation of audit firms following the Sarbanes-Oxley Act of 2002. While some believe that mandatory audit firm rotation is the only way to ensure auditor independence, most audit firms and their clients do not believe that mandatory audit firm rotation would impact auditor behavior. This study advances this debate by investigating how mandatory rotation may affect the process of auditor-client negotiations that produce financial statements.  Auditor-client negotiation is important to auditing because it is a natural process of reconciling incentive-induced differences in financial reporting.  Below are the objectives that the authors address in their study: 

    • Investigate how mandatory audit firm rotation (hereafter, mandatory rotation) affects auditor-client negotiations.
    • Examine the process differences in auditor-client negotiation with and without mandatory rotation – examine whether these process differences lead to material changes in the financial statements.
    • Examine the negotiation strategies used by both the auditor and the client and relate those strategies to the negotiated outcomes.  
    • Examine the impact on market dynamics as a result of auditor rotation.
    Design/Method/ Approach:

    The authors collected their evidence via a laboratory negotiation experiment using an abstract setting.  The data was collected prior to 2009.  Participants were graduate business students and were randomly assigned the role of manager (i.e., client) or verifier (i.e., auditor).  Participants were paired, one manager and one verifier, and completed a negotiation task.  For half of the negotiation pairs, mandatory rotation was required after three periods and for the other half of the pairs there were no rotation requirements.  Cash incentives were used to model the “real-world” incentives of clients and auditors.  The negotiation process, auditor and verifier strategies, and outcomes were compared between these two groups.

    Findings:
    • Mandatory rotation reduces the auditor’s relative importance of maintaining a relationship with the client. 
    • Auditors are more likely to use an obliging strategy (i.e. cooperating) under no mandatory rotation, as compared to mandatory rotation.
    • Auditors are more likely to use a strategy of inaction (i.e. unwillingness to compromise) under mandatory rotation (7%) compared to no mandatory rotation (1%).
    • Managers are less likely to send contending messages under mandatory rotation (17.6%), compared to no mandatory rotation (22%).
    • Auditors are less cooperative under mandatory rotation than under no mandatory rotation.
    • The agreement rate of negotiations under mandatory rotation is significantly lower than that under no mandatory rotation.
    • When negotiations result in agreement, the asset values under mandatory rotation are significantly lower (consistent with the auditor’s preferences) than those under no mandatory rotation.
    • In summary, under mandatory rotation auditors adopt less cooperative negotiation strategies, produce results that are more in line with the auditor’s preferences than with the client’s preferences, and less negotiations end in agreement.
    Category:
    Independence & Ethics, Auditor Judgment, Engagement Management
    Sub-category:
    Audit Firm Rotation, Prior Dispositions/Biases/Auditor state of mind, Interactions with Client Management, Audit Firm Rotation
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  • Jennifer M Mueller-Phillips
    The Joint Effects of Multiple Legal System Characteristics...
    research summary posted June 22, 2017 by Jennifer M Mueller-Phillips, tagged 01.02 Changes in Audit Standards, 15.04 Audit Firm Rotation 
    Title:
    The Joint Effects of Multiple Legal System Characteristics on Auditing Standards and Auditing Behavior
    Practical Implications:

    Whether or not the ISA should be adopted by the United States is a greatly contested topic. This study is helpful for regulators and standard-setting boards in the United States about the potential effects of the adoption of ISA and mandatory audit rotation for the United States. This information is also applicable for other countries when making these decisions as well.

    Citation:

    Simunic, Dan A., M. Ye, and P. Zhang. 2017. “The Joint Effects of Multiple Legal System Characteristics on Auditing Standards and Auditor Behavior”. Contemporary Accounting Research 34.1 (2017): 7.

    Purpose of the Study:

    This paper examines the impacts of legal characteristics and auditing standards on audit behavior. Then based on this information the authors determine what the optimal auditing standards would be under different legal regimes. The two legal characteristics examined are vagueness in interpreting audit standards by courts and the expected damage award size in lawsuits against auditors for a failed audit. In recent years there has been a large number of countries adopting the International Standards on Auditing (ISA). Specifically, this study addresses whether or not ISA can be applied efficiently for all countries, and whether or not it adds value to the country that adopts the standards. 

    Design/Method/ Approach:

    The authors begin the analysis by determining the audit quality based on auditing standards and the legal system by using a single-period auditing model with risk-neutral players. After that the optimal auditing standards which maximize audit quality for a specific legal system were determined. The effect of auditor rotation on audit quality was found by adding contingent fees into the model.

    Findings:

    Overall, the authors find that audit quality is affected by both auditing standards and characteristics of legal systems. The optimal audit standards for a particular country also change depending on the legal system.

    Specifically, the authors find:

    • In situations where the expected damages are low, the audit standards are not able to increase audit quality. This is also true for a vague interpretation of audit standards by the courts. Simply adopting a set of rules, such as the ISA, does not determine audit quality.
    • Mandatory auditor rotation can improve audit quality and is more beneficial in countries that have tough and vague auditing standards.

    In regards to ISA the authors find:

    • In places that already have similar standards and legal systems, such as Canada, ISA can be effectively implemented.
    • However, in countries that have a weak legal system, such as China, it is not likely the adoption of ISA will affect audit quality.
    • It is hypothesized by the authors that due to the litigious legal environment of the United States the adoption of ISA would decrease audit quality. 
    Category:
    International Matters, Standard Setting
    Sub-category:
    Changes in Audit Standards
    Home:

    http://commons.aaahq.org/groups/e5075f0eec/summary

  • Jennifer M Mueller-Phillips
    Auditor-Client Compatibility and Audit Firm Selection
    research summary posted February 27, 2017 by Jennifer M Mueller-Phillips, tagged 11.0 Audit Quality and Quality Control, 15.0 International Matters, 15.04 Audit Firm Rotation 
    Title:
    Auditor-Client Compatibility and Audit Firm Selection
    Practical Implications:

     The authors’ results may be of interest to policy makers for two important reasons. First, regulatory discussions on mandatory audit firm rotation could have implications for the cost and quality of auditing if a client is forced to switch from a compatible auditor to one that is less compatible. Second, proposals to expand the auditor’s reporting responsibilities might mitigate the loss of audit quality when similarity arises in unaudited disclosures.

    Citation:

     Brown, S. V. and W. R. Knechel. 2016. Auditor-Client Compatibility and Audit Firm Selection. Journal of Accounting Research 54 (3): 725-775.

    Purpose of the Study:

     A great number of factors affect the complicated process of a client selecting an auditor. The factors that might affect the degree of compatibility between an auditor and a client include pricing, expertise, location, interpersonal associations and the extent of agency problems in the client. Research in the past has looked into some of these attributes and how they are relevant in determining the overall quality of the resulting audit. A limited amount of research has examined alignment between clients and certain types of auditors based on factors such as the size of the audit firm or degree of industry specialization. However, there is less research on the compatibility of specific auditors and specific clients. The authors define auditor-client compatibility as the ability of the auditor to satisfy a client’s preferences, given the auditor’s own preferences, abilities and constraints. With this in mind, the authors examine the narrative disclosures included in the text-based parts of the financial statements that provide information about a company, its operations and its accounting choices. Next, they develop a unique measure of auditor-client compatibility for Big 4 firms based on the similarity of their financial disclosures rather than their financial results.

    Design/Method/ Approach:

     The authors focus on three narrative disclosures separately and together: the company’s business description, the accounting footnotes, and management discussion and analysis. They also compare the similarity of an individual client to all of the current clients within an industry of a specific auditor to generate a proxy for how well that company fits into each auditor’s client base.

    Findings:
    • The authors find that clients clustered within an industry at the audit firm level tend to have higher similarity scores when compared to clients of other auditors in the same industry and time period; this suggests that the authors’ proxy is capturing information about the compatibility between an individual client and an individual audit firm.
    • The authors find that the poorer the fit with an existing auditor, the greater the probability the client will choose to switch to a new auditor.
    • The authors find that the successor auditor is generally the non-incumbent firm that has the best relative fit.
    • The authors find that discretionary accruals are lower when auditor-client compatibility is better, suggesting higher audit quality; however, they find a higher incidence of accounting restatements when the similarity of the unaudited MD&A and client business description is high but not when the similarity of the audited footnotes is high.
    • The authors find that financially distressed firms that are more similar are less likely to receive a going concern opinion, but similarity is also associated with increased accuracy in going concern opinion reporting. 
    Category:
    Audit Quality & Quality Control, International Matters
    Sub-category:
    Audit Firm Rotation
  • Jennifer M Mueller-Phillips
    Competition in the Audit Market: Policy Implications.
    research summary posted January 19, 2016 by Jennifer M Mueller-Phillips, tagged 15.0 International Matters, 15.04 Audit Firm Rotation 
    Title:
    Competition in the Audit Market: Policy Implications.
    Practical Implications:

    This study predicts economic effects of both mandatory audit firm rotation and the contraction of the audit market to 3 major audit firms. The authors estimate that mandatory audit firm rotation would reduce consumer surplus ranging from $2.7 billion to $5 billion depending on the length of time between required rotations (10 or 4 years, respectively). They also find that the contraction of supply from 4 major audit firms to 3 major audit firms would reduce client firms’ surplus between $1.4 and $1.8 billion. Finally, the authors estimate that audit fees would increase for client firms by approximately 12% (5%) as a result of mandatory audit firm rotation (audit firm contraction). Therefore, it appears that the occurrence of either of these events would be damaging to client firms. However, the estimates do not take into consideration the potential benefits associated with mandatory audit firm rotation such as increased auditor independence and possibly higher audit quality.

    Citation:

    Gerakos, J. and C. Syverson. 2015. Competition in the Audit Market: Policy Implications. Journal of Accounting Research 53 (4):725-775.

    Keywords:
    auditing, mandatory rotation, competition
    Purpose of the Study:

    This study explores the effects of two possible market scenarios within the audit market that have been the focus of policy discussions: 1) Mandatory firm rotation and 2) Supply concentration resulting from contraction of “Big 4” audit firms to 3 audit firms. Policy makers are interested in the audit market due to its role in the transparency of capital markets, but also because of its unique combination of mandated demand and concentrated supply. For example, publicly traded firms require an audit by the SEC, yet 67% of audit engagements and 94% of audit fees are concentrated within only 4 audit firms. Thus, policy makers have frequently expressed concerns about auditor independence which has led to the PCAOB exploring the possibility of mandatory audit firm rotation. Policy makers have also been concerned of resulting effects if further supply concentration occurred, potentially as a result of litigation from negligence. This study estimates the demand for audit services among publicly listed firms to develop a framework of how client choose their audit firms which is then used to measure in dollar terms values of substitutability of audit firms for clients. Resulting information is then combined across thousands of client firms’ choices to determine the valuation of audit firms by different clients. More specifically, the authors calculate the monetary transfer that would be necessary to compensate clients for the loss of choice of one Big 4 audit firm.  

    Design/Method/ Approach:

    The data used in this research is from a sample of SEC registrants between 2000 and 2010 and gathered publicly available data of audit fees and restatements from Audit Analytics and from other publicly available sources. Data was collected prior to January 2014.  

    Findings:
    • For U.S. publicly traded firms, mandatory audit firm rotation would induce consumer surplus losses of approximately $2.7 billion ($4.7-$5.0 billion) if rotation were required after 10 (4) years.
    • The exit of one of the Big 4 firms would reduce client firms’ surplus by $1.4-$1.8 billion.
    • Audit fee increases could range from $0.75 to $1.3 billion per year as a result of mandatory rotation and $0.47-0.58 billion per year if a Big 4 firm ‘disappeared’.
    • Result is economically significant compared to total audit fees for public firms of $11 billion in 2010.
    Category:
    International Matters
    Sub-category:
    Audit Firm Rotation
  • Jennifer M Mueller-Phillips
    Are There Adverse Consequences of Mandatory Auditor...
    research summary posted July 27, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 15.0 International Matters, 15.04 Audit Firm Rotation 
    Title:
    Are There Adverse Consequences of Mandatory Auditor Rotation? Evidence from the Italian Experience.
    Practical Implications:

    The consequences of mandatory rotation appear to be (1) higher audit fees, and (2) lower-quality audited earnings following rotation (which is consistent with the evidence in non-mandatory settings). The authors conclude with some conjectures on how the negative effects of mandatory rotation observed in Italy might be even greater in countries with larger audit markets and larger clients, such as the United States and other European Union countries, which should give regulators pause. Another unintended consequence of mandatory rotation in the United States would be to reduce an audit firm’s industry expertise. A rotation rule in the United States and other large economies could disrupt the market and fundamentally change the way accounting firms are organized for the delivery of audits. 

    Citation:

    Cameran, M., Francis, J. R., Marra, A., & Pettinicchio, A. 2015. Are There Adverse Consequences of Mandatory Auditor Rotation? Evidence from the Italian Experience. Auditing: A Journal of Practice & Theory 34 (1): 1-24.

    Keywords:
    audit fees, audit market regulation, auditor rotation, earning quality
    Purpose of the Study:

    Mandatory auditor rotation was recently proposed for the European Union and is also under consideration in the United States. On April 24, 2013, the Legal Affairs Committee approved a proposal for a 14-year rotation rule. However, the full European Parliament has not yet acted on the recommendation. At the heart of the case for mandatory rotation is the belief that bad things can happen when auditors have long tenure. On the other hand, it may be the case that bad things do happen in the short-tenure setting due to a learning curve effect. Short tenure occurs when there is a change in auditor and there is evidence that earnings quality is lower during the first few engagement years, which is consistent with a learning curve on new audits.

    There has been little research into either the benefits or costs of rotation in a true mandatory setting that could inform intelligent policy making. Given the existing body of evidence, it appears the European Commission is advocating a major change to the audit market that is not supported by extant research. Even worse, the Commission could cause lower quality audits since there would be more frequent auditor changes under a mandatory rotation rule and, therefore, more frequent audits with short tenure and potentially lower quality. This paper helps fill this gap by examining Italy, where mandatory rotation of auditors has been required since 1975, and examines potential negative consequences of mandatory audit firm rotation.

    Design/Method/ Approach:

    The sample is comprised of 204 publicly listed companies in Italy audited by the Big 4 accounting firms over the period 20062009, resulting in 667 firm-year observations in the sample, although the specific sample size varies from test to test depending on data availability. The sample has 52 auditor changes, 36 of which are mandatory rotations (17.6 percent of firms), plus another 16 auditor changes that are voluntary (7.8 percent of firms). 

    Findings:
    • First, for the outgoing auditor, there is no evidence of lower-quality audits due to shirking in the final-year engagement. However, there is some evidence of abnormally higher fees, as the final-year fees are 7 percent higher than normal. This suggests there may some opportunistic pricing, since the authors find no evidence of abnormally higher audit effort in the final-year engagement. The PCAOB report does not identify this as a negative consequence, but the evidence suggests it adds to the cost of mandatory rotation.
    • Second, for the incoming auditor, audit effort (hours) is abnormally higher by 17 percent in the initial engagement, but initial fees are discounted by 16 percent relative to ongoing engagements. However, the authors also find that future audit fees following the first-year audit are abnormally higher by approximately 76 percent of first-year fees.
    • Third, the authors document that earnings quality is lower during the first three engagement years relative to later years of auditor tenure (large abnormal accruals and less timely loss recognition). On average, abnormal accruals are 36 percent larger in the first three years relative to later years of tenure.
    Category:
    Client Acceptance and Continuance, International Matters
    Sub-category:
    Audit Fee Decisions, Audit Firm Rotation

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