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.

http://www.auditingresearchsummaries.org

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.

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

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.

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.

• 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.

 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. 

www.auditingresearchsummaries.org

This study sheds light on what underlies decision making in the imperative audit committee responsibility of auditor appointment: nuanced interactions and power asymmetry among management, the audit committee, and auditors. The auditors viewed the CFO as the client and tailored the proposal accordingly. The audit committee will not be effective unless both auditors and audit committee members fundamentally change their mindsets about their respective roles in relation to client management. As large public companies employ multiple Big 4 firm, the viability of severing existing relationships to bring in a truly independent auditor mindset through audit firm rotation is questionable.

Fiolleau, K., Hoang, K., Jamal, K., & Sunder, S. 2013. How Do Regulatory Reforms to Enhance Auditor Independence Work in Practice? Contemporary Accounting Research 30 (3): 864-890.

This article presents a study on regulatory reforms that aim to enhance auditor independence work. In order to achieve the right balance between the auditors serving commercial versus professional interests, regulators implemented a set of alternative remedies that include mandatory audit partner rotation and enhanced audit committee responsibilities, expertise and independence. As of September 2013, regulators based in Europe and the U.S. are considering to extend rotation requirement to encompass audit firm rotation rather than partner rotation. In this paper, the authors conduct a field study to investigate how regulatory reforms designed to promote auditor independence (specifically audit committee reforms and proposed audit firm rotation requirements) may actually work in the context of auditor change. This study of auditor change also yields insights into the potential consequences of increasing the frequency of auditor–client courtships through mandatory audit firm rotation, which has recently been proposed by regulators as a way of reinforcing auditor independence. The underlying premise is that audit quality would be enhanced by weakening the economic and relationship bonds between auditors and their clients. The authors investigate how the audit committee interprets and executes its legislative mandate in appointing an independent external auditor.

The authors collected data six months after the company’s RFP process and new auditor appointment. The authors obtained a copy of the company’s RFP document from the CFO, and copies of the bid documents directly from all Big 4 audit firms who bid for this audit. They interviewed the company’s CFO and the chair of the audit committee. The authors interviewed each of the four proposed engagement audit partners for 60-90 minutes.

• 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.

http://www.auditingresearchsummaries.org

The adoption of mandatory partner rotation in many countries suggests that regulators believe that the benefits of rotation outweigh the costs and thus a policy of mandatory rotation enhances audit quality. The results of this study provide initial evidence of the effects of mandatory partner rotation on audit quality. Contrary to regulators’ beliefs, the findings do not support the assumption that audit partner rotation will lead to audit quality increases. One caveat to these findings is whether the findings will generalize to other countries with different regulatory and legal regimes.

Chi, W., H. Huang, Y. Liao, and H. Xie. 2009. Mandatory audit partner rotation, audit quality, and market perception: Evidence from Taiwan. Contemporary Accounting Research 26 (2): 359-391. 

Bamber, E.M., and L.S. Bamber. 2009. Discussion of “Mandatory audit partner rotation, audit quality, and market perception: Evidence from Taiwan”. Contemporary Accounting Research 26 (2): 393-402.

The Sarbanes-Oxley Act of 2002 (SOX) reduced the period that an audit partner is allowed to serve a particular client from seven consecutive years (required by the AICPA since the 1970s) to five years. The assumption behind the mandatory rotation requirement is that rotating the audit partner will improve auditor independence and audit quality. Research on audit firm rotation in the U.S. suggests that longer audit firm tenure with a client increases audit quality.  Although, as Bamber and Bamber point out, the results of audit firm rotation may be different than audit partner rotation because the costs and benefits are quite different.  For example, in rotating audit firms, the new firm brings an entirely new audit team and a new audit methodology. In rotating an audit partner, many factors continue to be the same under the new partner (the team, the overall audit methodology, the firm’s history with the client, etc.). Due to the lack of audit partner data in the U.S., this study utilizes audit partner data from Taiwan to assess the effect of mandatory audit partner rotation on audit quality. More specifically, the authors address two primary issues:

• The authors 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.

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). 

• 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.