Independence is the cornerstone of the accounting profession. Without it, any opinion rendered cannot be relied upon by outside parties. An auditor must not only be independent in fact but also in appearance. According to Hill and Booker (2007), both are studied to understand what independence is required in the profession but research evidence related to independence in fact requires far more effort as it involves information that is not always publicly available (as cited in Daniels and Booker, 2011, pp. 79).
In previous years, it has been a common practice that auditing firms also provide tax and consulting services to the same clients. However, due to the downfall of huge companies such as Enron resulting from corporate fraud and financial reporting failures, the government has tightened the responsibilities of auditors and key corporate officers on the faithful representation of financial statements through laws such as the Sarbanes-Oxley (SOX) Act of 2002. The idea of auditor partner rotation and audit-firm rotation has been enforced as a solution to preventing similar accounting scandals from happening again but would it be more beneficial or disadvantageous?
Audit partner rotation focuses on employing different individuals from the same auditing firm for every audit engagement with the same client. Audit-firm rotation is more concerned with the maximum tenure an auditing company is allowed to keep an audit client. It is tool used to improve audit independence by providing a limit as to the number of consecutive years a public firm stays to be an audit client of the same auditor. Specific requirement of the SOX involves mandatory rotation of the concurring reviewer and the lead audit partner every five years (SOX, 2002, pp. 29). Mandatory auditor rotation addresses question related to auditor independence, which in turn, is associated with audit quality. The auditor’s objectivity regarding the client is reduced with the passage of time. Thus, with increased audit tenure, many believe that audit quality is decreased.
In a study done by the General Accounting Office as required by the SOX, interviews with Fortune 1000 companies and a majority of the largest accounting firms revealed that costs associated with audit rotation are more likely to exceed its benefits. Responses of other parties that include investors, independent accountants, and the public in general were also in agreement related to costs (as cited in Daniels and Booker, 2011, pp. 79).
As it has been made apparent, knowledge is important in providing audit services. It is considered a critical input in the detection of material misstatements and a great deal of which is client-specific information. This means that an auditor only obtains a deeper understanding of the client’s business with time resulting to its comparative advantage (as cited in Johnson et. al., 2002, pp. 642). Therefore, an audit engagement during which an auditor has lesser client-specific knowledge would most likely lead to the non-detection of material misstatements during the early years. For many auditing firms, rotation will result to higher start-up costs arising from the loss of institutional knowledge on a previous client and steeper learning curve. While it is true that the lack of client-specific knowledge on initial engagement can be compensated by employing additional procedures, they cannot be perfect substitutes themselves. Therefore, if the goal is to provide better financial reporting quality, it is necessary that client-specific knowledge should be widened However, this becomes more difficult with audit rotations as auditing firms would have to lose the comparative advantage that they have acquired with every new client. There is also a higher chance of litigation against auditing firms arising from negligence in the performance of an audit in the early years of engagement due to insufficiency of knowledge related to newly acquired clients (Geiger and Raghunandan, 2002, pp. 68).
Audit rotations increases the risk of audit failure since the incoming auditor has to rely more on management’s estimates and representations when performing the initial engagement. This is an issue for the audit client since they would naturally prefer auditors who know their business better. Managers believe a well-studied business is made possible with experience and concerns with new auditors include whether they have the required minimum industry expertise or if they would be willing to exert additional effort in performing the audit.
Proponents of audit rotations also base their notion on the belief that extended tenure leads to auditor complacency on the presentation of financial results (Myers, 2003, pp.779). The independence of auditors could be decreased which can result to the increased likelihood of supporting more aggressive accounting practices by the management. Also, it could lead to auditors may agree with extreme and self-serving choices by the client in the presentation of its financial statements. Ultimately, these could result to failure in detecting material misstatements and corporate fraud. According to Biggs (2002), audit rotation can address instances of low-balling and the revolving door phenomenon (as cited in Daniels and Booker, 2011, pp. 79). These are associated with the auditor’s incentives during the early years of the engagement.
Low-balling is a natural competitive response of auditors. It works by pricing the initial audit fee below the avoidable costs of an audit to guarantee obtaining the client. The threat of early dismissal of audit services by the public company can significantly impair judgment of the auditors and encourage them to report a more favorable financial condition. In effect, they would retain the client long enough to recoup the initial year’s losses. Auditors during the initial engagement will tend to be more accommodating to client requests to limit the losses on the current engagement and ensure the stream of offset payments from quasi-rents on repeat engagements (Geiger and Raghunandan, 2002, pp.70). These quasi-rents are a result of high start-up costs incurred by the client and the auditor. Mandatory auditor rotation will provide a stronger stance to resisting management pressure and give way for auditors to exercise objectivity in their professional judgment.
However, a study published in 2002 revealed evidence that longer tenure do not equate to decreased audit quality. It was found that short-audit firm tenures of two or three years resulted to lower quality of financial reporting while there were not evidence to suggest that financial reporting quality were reduced with longer audit tenures (Johnson et. al., 2002, 640). It has also been observed that there was greater management intervention related to earnings and accruals for short audit-firm tenures but had no significant difference for longer audit-firm tenures. Thus, the study has shown the role of tenure as to obtaining client-specific knowledge and how management can assert its estimates and representations given that the new auditors are not yet completely familiar upon initial engagement.
Audit rotation is no longer a new concept as it has already been implemented in many countries such as Spain, Israel, Brazil, and Italy. Many advantages and drawbacks need to be considered in deciding whether mandatory implementation is necessary. Several disadvantages of audit rotation should be noted including increased costs for both the auditing client and the auditor, steeper learning curves, and ironically, increased likelihood of audit failures. However, the greatest advantage of the audit rotation would be audit independence. For this reason, audit quality can also be significantly improved.
Bibliography
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Daniels, B. W. & Booker, Q. (2011). The Effects of Audit Firm Rotation on Perceived Auditor Independence and Audit Quality. Research in Accouting Regulation, 78-82.
Geiger, M. & Raghunandan, K. (2002). Auditor Tenure and Auditor Reporting Failures. Auditing: A Journal of Practice and Theory, 68-78.
Hill, C., & Booker, Q. (2007). State Accountancy Regulators’ Perceptions of Independence of External Auditors When Performing Internal Audit Activities for Nonpublic Clients, 43-57.
Johnson, V. E., Khurana, I. K. & Reynolds, J. K. (2002). Audit-Firm Tenure and the Quality of Financial Reports. Contemporary Accounting Research, 637-660.
Myers, J.A., Myers, L. A. & Omer, O. T. (2003). Exploring the Term of the Auditor-Client Relationship and the Quality of Earnings: A Case for Mandatory Auditor Rotation?. The Accounting Review, 779-799.
U.S. General Accounting Office (GAO). (2003). Public Accounting Firms: Study on the Potential Effects of Mandatory Audit Firm Rotation,1-48.
U.S. House of Representatives. (2002). The Sarbanes-Oxley Act of 2002, 1-66.
