Auditing Section Research Summaries Space

A Database of Auditing Research - Building Bridges with Practice

This is a public Custom Hive  public

research summary

    An Analysis of Forced Auditor Change: The Case of Former...
    research summary posted May 7, 2012 by The Auditing Section, last edited May 25, 2012, tagged 03.0 Auditor Selection and Auditor Changes, 03.01 Auditor Qualifications, 04.0 Independence and Ethics, 04.07 Audit Firm Rotation 
    1201 Views, 1 Comment
    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.


    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.

    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.

    • 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.
    Auditor Selection and Auditor Changes, Independence & Ethics
    Auditor Qualifications (e.g. size - industry expertise), Audit Firm Rotation, Audit Firm Rotation
    home button



    • Robert E Jensen

      A few surprises of professors coming out in favor of audit firm rotation
      "PCAOB Hears Evidence Favoring Auditor Rotation," by Tammy Whitehouse, Compliance Week, October 18, 2012 ---

      Audit research experts have presented the Public Company Accounting Oversight Board with evidence they say demonstrates auditor rotation leads to better audit quality.

      During its Houston roundtable to discuss whether mandatory rotation would improve audit quality, Scott Whisenant, an associate professor of accounting at the University of Kansas, reviewed a variety of academic studies for the board that suggest rotation would produce benefits the board is seeking. He noted much of the protest around mandatory rotation has focused on costs, but few studies have focused on possible benefits because rotation is practiced in only a handful of countries.

      The results of a 2000 study suggest, he said, that long-term auditor client relationships significantly increase the likelihood of an unqualified opinion, which raises questions about audit quality. The exception, however, is the last year of the relationship, when the likelihood of an unqualified opinion drops. “In this final year, the auditors finally drop the hammer down on clients,” Whisenant said, knowing they are about to surrender the job to a successor firm that will no doubt review their work.

      Whisenant said his own more recent research with another coauthor suggests that in countries where rotation is practiced there's evidence of less earnings management, less managing to meet earnings targets, and more timely recognition of losses. The study concludes the quality of audit markets improves after the enactment of rotation, he says, and evidence suggests that concerns about any disruption or difficulty of transition to a new audit firm are more than offset by benefits. “Depending on the statistics we investigated, the benefit to audit quality of adopting rotation rules appears to be larger by a factor of at least two, and in some cases more, than the cost of audit quality erosion at the forced rotation of audit engagements,” he said.

      Stephen Zeff, accounting professor at Rice University, told the PCAOB auditors have become more commercial and less professional over the past several decades, driven there by an education process that preaches memorization of standards more than critical thinking and an allowance for auditors to develop business relationships with their clients. Karen Nelson, another accounting professor from Rice, said her review of academic research suggests auditors working under the present model are more likely to issue a report biased toward management than under practically any other arrangement  that would involve mandates on rotation or retention.

      PCAOB Chairman James Doty praised the “extraordinary array of views” presented by the academics. “This is where we we wanted to get to with the concept release,” he said, where the board could begin to digest empirical evidence that would suggest what regulatory regime is most likely to produce objective, professional, skeptical audits. The webcast archive of the Houston roundtable will be available on the PCAOB website.


      Jensen Comment
      A few of my AECM friends have repeatedly argued for audit firm rotation, including Tom Selling and David Albrecht. Now it turns out that some other professors mentioned above are coming out of the woodwork in favor of such rotation as well.

      It would seem that the PCAOB wants audit firm rotation so badly that, in spite of the overwhelmingly negative comments received in various invitations to comment, the Board just keeps coming back for more support in favor of rotation..

      I'm on record as being against it for various important reasons. One is cost since there are so many costs of gearing up for a first-time audit, especially a large multinational client with offices and factories spread about the world. I can't imagine the cost of gearing up for a first time audit of GM, GE, Exxon-Mobil, etc. Second, the new costs will be added to pressures on audit firms by the PCAOB to conduct more costly audits, including much more detailed testing ---

      It's naive to assume that clients will remain passive and simply cough up the millions or tens of millions of dollars added in rotation-based fees billed by their auditors. Instead, get ready for intense lobbying in Washington DC to overturn any PCOAB audit firm rotation mandate and more intense lobbying to overturn SarBox legislation that created the PCAOB in the first place. I think that attention given to the audit firm rotation issue may merely be a pretense by the PCAOB in an effort to scare audit firms and raise added concerns about audit independence. Does the PCAOB really want to go toe-to-toe with Corporate America as well as companies headquartered around the world who listed on the NYSE?

      Equally important in my mind is what rotation will do to the quality and skills of auditors on the job. First there is the inevitable relocation that will come from shifting from a huge client headquartered in one city to another big client headquartered thousands of miles away. Even with medium-sized clients in smaller cities there will be inevitable stresses of having to uproot families and move. For example, after giving up an audit of USAA in San Antonio hundreds of auditors may have to move to Dallas, Houston, NYC, Washington DC or who knows where.

      I'm not alone. A raft of other highly respected professors claim the following ---

      We understand and affirm the importance of auditor independence, objectivity and scepticism for the proper functioning of the U.S. capital market and are supportive of the PCAOB’s desire to enhance the actual and perceived independence of auditors. However, academic research on the topic suggests that adopting a system of audit firm rotation will not help the U.S. economy achieve these worthy goals. Instead, such a change may impair auditor independence, weaken audit expertise and undermine corporate governance.

      We organize our response below in terms of impact on objectivity (especially opinion shopping), and development of expertise. We note that many of the views expressed in our letter are influenced by a detailed research study conducted by Fiolleau et al. (2010) on how companies currently choose auditors. A copy of this study is publicly available at Of course, any such study is limited in its generalizability. In particular, Fiolleau et al. (2010) examines cases where audit committee’s have voluntarily chosen to seek competing bids from auditors. However, we think the studies’ observations are suggestive of what is likely to happen on an economy-wide basis if PCAOB were to mandate periodic rotation of audit firms. Some of our other comments are based on other research evidence, which we cite.

      Selection and appointment of auditors by their clients is a major source of concerns about real and perceived independence and objectivity of the auditors. Since the PCAOB seems to be unwilling to deal with this root cause of the independence problem at this time, other reforms are being sought. No audit can be perfect, and the quality of audit is determined not only by independence but also by many other factors—such as the quality of accounting standards, accounting education, auditor expertise, audit committees, corporate governance, auditor discipline, liability, and a host of other institutional features of the audit environment. The focus of PCAOB should be to provide the best audit quality, and not to fixate on any subset of such determinants of audit quality. Our reading of existing research leads us to conclude that, in spite of its superficial appeal, audit firm rotation is a bad policy choice on all relevant dimensions. We explain our reasons below.

      Rotation and Auditor Objectivity
      The most appealing and common sense intuition underlying auditor rotation is that it promotes objectivity by refreshing the personnel (or firm) who are not tied down by judgments, compromises, and personal relationships of the past. A new auditor brings a fresh set of eyes, and has the opportunity to raise issues that have been overlooked or settled in the past. Research experiments show that new auditors are better able to identify issues, alter their judgments, and bring issues up for discussion when they are not personally committed to prior decisions (see article by Tan on p. 113-35 in Spring 1995 issue of Journal of Accounting Research).

      Our first observation on this rationale for firm rotation is that familiarity arises between individuals (e.g., the audit partner and the CFO) not firms, so most of the benefit from taking a “fresh look” can be obtained more simply by rotating the partner and or other senior personnel on the audit team (e.g., audit manager). Since the policy of partner rotation is already in place, audit firm rotation is unlikely to add any significant marginal benefit, especially when the considerable costs of firm rotation are taken into account. The GAO’s (2003) study on mandatory audit firm rotation estimated increased initial audit costs of more than 20% (some studies in Europe suggest 40%) and this did not include costs incurred by the audit committee and management to conduct the tendering process.

      Our second observation from the research study by Fiolleau et al. (2010) is that although the auditors are supposedly appointed by the audit committee of the client company, management plays a significant role in the process, and may even dominate it for all practical purposes. This means that a mandate for audit firm rotation will force the incumbent and potential auditors into a “beauty contest” every few years. The market power of the audit firms is so much weaker than the power of their clients that, at the time of bidding for engagement, the former compete among themselves to convince the management / audit committee of their potential clients of their commitment, service, and responsiveness. Each hiring exercise becomes an opportunity for opinion shopping by clients, lowballing of audit fees and demonstrations of loyalty and relationship-building by the auditors. Many of the auditor behaviours that the rotation proposal is intended to discourage get exacerbated when the audit firm enters into a beauty contest (bidding war) to get an audit engagement.

      A third observation from the Fiolleau et al., (2010) study is that, with only four large international firms, the audit market is highly concentrated. Most large clients already receive one service or another from every one of the four firms. If one of these accounting firms audits the client, the other three often provide it a host of advisory services in tax, valuations etc. This perpetual engagement and pre-existing relationships of most large companies with all four audit firms implies that there is only limited opportunity for mandatory rotation to bring about a “fresh look.”A large corporation would have to deliberately avoid business engagement with one Big 4 firm, to have at least one firm who would meet current independence rules and have the expertise needed to conduct the audit. The PCAOB proposal is likely to yield little by way of benefits and incur the additional harm associated with increased frequency of “beauty contests.”

      Rotation and Auditor Expertise
      There is compelling evidence that audit firm rotation will impair auditor expertise. PCAOB’s concept paper indicates awareness that the auditor is most vulnerable to missing fraud in a new engagement (see also St Pierre and Anderson on p 242-63 in Vol 59(2), 1984 issue of The Accounting Review). A variety of studies (e.g., Myers et al., on p 779-799 in Vol 78, July 2003 issue of The Accounting Review) show that the quality of accounting numbers improves with increases in auditor tenure. The most compelling force disciplining accounting accruals is auditor industry expertise (see Craswell et al., on p 297-322 in December 1995 issue of Journal of Accounting and Economics). While academic evidence is seldom conclusive, the weight of evidence suggests that a policy of mandatory auditor rotation undermines expertise formation and will impair audit quality. The thrust of Generally Accepted Accounting Principles (GAAP) is increasingly oriented to having management communicate to investors how they operate the business. Auditors’ understanding of the substance of client business would be undermined if they are rotated out every few years. The Fiolleau et al (2010) study reveals that even the four largest audit firm’s lack depth of expertise in serving large corporate clients across all industries outside the main business centres such as New York, Toronto, London, and Tokyo. For clients with headquarters located in smaller cities, finding industry specialists in the local offices can be a significant challenge.

      Improving Audit Quality
      Audit quality is not just an attribute of the auditor alone. The nature of Generally Accepted Accounting Principles (GAAP) is also a major determinant of audit quality. Over the recent decades, the Financial Accounting Standards Board (FASB) has set standards that de-emphasize

      verifiability in favour of the mark-to-market valuation, no matter how illiquid the market may be. It has also adopted a practice of writing detailed standards in its attempt to close loopholes but ends up creating new ones. Exploitation of the Repo 105 rules by financial service firms during the recent crisis is a good example. This type of standards place auditors in a very difficult position vis-à-vis corporate management. The shift in GAAP towards the so-called “fair value accounting” is a major factor undermining audit quality.

      Importance of Audit Resignation as a Signal
      When financial press reports that company X audited by firm Y for the past twenty years has changed its auditor, investors get a valuable and informative warning signal that draws close scrutiny by the investment and regulatory communities. PCAOB’s mandatory rotation proposal will eliminate this signal by making auditor changes a matter of routine, deserving little attention or scrutiny, and thus undermine the quality of audit.

      Transfer of Audit Resources from Verification to Marketing
      The PCAOB proposal, by eliminating all long-term client-auditor relationships, will induce audit firms to devote even greater resources to marketing themselves to potential clients. These resources can only come from cutting back on the substantive work of verification during the course of their audits or by raising audit fees. Individuals in the audit firm will find their presentation and marketing skills becoming more valuable relative to their technical accounting and auditing skills.

      Confusion and Unintended Consequences from Too Many Initiatives
      Auditors now face a very complex economic and social environment. There are economic incentives to be responsive to management but these have to be balanced with incentives emanating from audit committees, concurring review partners, national office reviews, litigation, GAAP and industry practice, and PCAOB reviews. In some countries two audit firms jointly conduct an audit making it difficult for any single audit firm to have consistency in its audits across countries as complex co-ordination is required across audit firms. Fraud cases like Parmalat are thought to have avoided detection due to lack of continuity of the auditor and presence of multiple audit firms. Adding more agents and incentives into this mix serves to create a very complex incentive structure, interpersonal friction and potential for unintended consequences as accountability and authority get distributed across a variety of agents. This increases moral hazard and the potential for confusion. Adding one more firm rotation requirement on top is not just a free good that improves the system. Too much complexity makes the audit process more vulnerable to systemic failure.

      Audit firm rotation is a bad policy prescription especially in an environment where auditors are appointed by board audit committees who often are significantly influenced by management. The potential benefits of rotation will be exceeded by the harm associated with the “beauty contest” that takes place to appoint a new auditor. Rotation actually impairs audit quality by promoting more frequent opinion shopping and lowballing. Rotation also impairs audit expertise, eliminates a valuable signal of auditor change, and shifts even more resources from substantive audit work to marketing of audit services.

      Most of the benefits of rotation can be realized by rotating the engagement partners. Because of limited depth of expertise, we suggest rotating engagement partners every ten years. Given the limited independence of most audit committees from the management, PCAOB’s goal of improving audit quality through firm rotation is beyond its reach. Pressing the FASB/IASB to pay greater attention to verifiability of financial reports would be a more effective avenue to improve audit quality.


      Tracey C. Ball, FCA ICD.D

      Executive Vice President & CFO Canadian Western Bank Group (TSX:CWB)

      Rozina Kassam,CA


      Jonathan Glover, PhD

      Professor of Accounting, Carnegie Mellon University

      Karim Jamal, FCA, PhD

      Chartered Accountants Distinguished Chair Professor, University of Alberta

      Ken Kouri FCA

      Retired Partner Kouri Berezan Heinrichs, CA

      D. Brad Paterson, CMA

      CFO, Wave Front Technology Solutions (TSX (V): WEE)

      Suresh Radhakrishnan, PhD

      Professor of Accounting, University of Texas at Dallas

      Shyam Sunder, PhD

      James L. Frank Professor of Accounting, Economics and Finance, Yale University


      The very best prospects for becoming accounting majors may be turned off by the gypsy-living prospects of becoming career CPA auditors. The very best seniors and managers and even partners on a particular audit may take up other job offers rather than uproot spouses and children to relocate as Sundowners ---

      There are many, many more very responsible concerns raised in the overwhelmingly negative responses received by the PCAOB --

      In particular read Response 35 (James L. Fuehrmeyer, Jr.) and Response 29 (Dennis R. Beresford) at