By Barbara Arel, Richard G. Brody, and Kurt Pany
In addition, regulators and the business press have shown interest in considering whether long-term relationships between companies and their auditors create a level of closeness that impairs auditor independence and reduces audit quality. Questions have arisen about whether SOA’s requirement to simply rotate personnel—the lead and review partners—within the same audit firm is adequate. SOA section 207 required the U.S. comptroller general to conduct a study to review the potential effects of requiring mandatory rotation of registered public accounting firms. The subsequent study by the General Accounting Office (now the Government Accountability Office), issued in November 2003, Public Accounting Firms: Required Study of the Potential Effects of Mandatory Audit Firm Rotation, concludes that the benefits of mandatory firm rotation were not certain and that more experience with the effects of SOA’s other requirements was needed. The study also acknowledged that nearly 99% of the Fortune 1000 public companies have no public accounting firm rotation policy.
Mandatory Audit Firm Rotation
The ultimate question about mandatory audit firm rotation is whether such a policy enhances audit quality, and if so, at what cost. Operationally, the primary audit quality question is whether such a policy will lead to more-independent auditors performing better audits by either detecting or reporting material misstatements in the financial statements, or whether the constant rotation of audit firms will result in inferior audit performance. Three related conditions affect issues of audit quality and audit firm rotation:
- Closeness to client management;
- Lack of attention to detail due to staleness and redundancy; and
- Eagerness to please the client.
Closeness to Management
Why audit firm rotation might be the answer. The nature of auditing requires that auditors interact extensively with their clients. Long-term relationships may result in a troublesome degree of closeness between management and the auditor. Enron and Andersen, its long-time audit firm, provide a graphic example:
Andersen auditors and consultants were given permanent office space at Enron headquarters here and dressed business-casual like their Enron colleagues. They shared in office birthdays, frequented lunchtime parties in a nearby park and weekend fund-raisers for charities. They even went on Enron employees’ ski trips to Beaver Creek, Colo. “[P]eople just thought they were Enron employees,” says Kevin Jolly, a former Enron employee who worked in the accounting department. “They walked and talked the same way … It was like Arthur Andersen had people on the inside … the lines become very fuzzy” (“Were Enron, Anderson Too Close to Allow Auditor to Do Its Job?,” by Thaddeus Herrick and Alexei Barrionuevo, The Wall Street Journal, January 21, 2002).
When a contentious issue arises, this close relationship may create a conflict of interest for the auditor that can adversely affect the audit process. The auditor could identify closely with management’s perspective and not exhibit sufficient professional skepticism. In addition, management can take advantage of the auditor’s conflict by making a personal appeal for compassion and support. Concern with this issue is not new. More than 40 years ago, in The Philosophy of Auditing, authors Robert K. Mautz and Hussein A. Sharaf warned auditors:
[T]he greatest threat to his independence is a slow, gradual, almost casual erosion of this honest disinterestedness—the auditor in charge must constantly remind his assistants of the importance and operational meaning of independence.
In 1985, Congressman Richard Shelby asked on the floor of the House of Representatives, “How can an audit firm remain independent … when it has established long-term personal and professional relationships with a company by auditing that company for many years, some 10, 20 or 30 years?” Congressman Shelby may have understated the duration of these relationships. A study released in 2003, GAO Kills Mandatory Auditor Rotation (Fulcrum Financial Group), found that the average auditor tenure for Fortune 1000 companies is 22 years—and it would have been much higher except for the demise of Andersen. Also, 10% of the companies in the study were found to have had the same auditor for 50 years, with the average tenure of this group being 75 years.
In addition to affecting the audit process, close auditor-management relationships have also resulted in many auditors being hired by former clients. This issue received increased attention when it was revealed that many Enron employees had previously worked for Arthur Andersen. Company personnel may be the auditors from the past, and current auditors may be auditioning for future employment. SOA includes restrictions on such hiring practices.
Why audit firm rotation might not be the answer. Even if one accepts the existence of a potential personal closeness to management as a problem, auditor rotation may not solve the problem. Auditors must interact with management on a daily basis during the audit, and such relationships are bound to occur regardless of the length of the audit relationship. Indeed, a client must feel comfortable with an auditor and be willing to share information and discuss problems when they exist. While auditors must always maintain a level of professional skepticism, this auditor-client communication is often a function of mutual experience. Examining documents is critical to an auditor, and client cooperation is tantamount. An auditor must be able to gauge when the client is not revealing all available information, and this often comes from knowing the client and its management. Auditors from a new firm are faced with a “getting to know each other” stage and are unlikely to have the necessary open, respectful professional relationship that builds over time. The close relationship contributes to knowledge-sharing and is critical to the audit process.
A close auditor-management relationship may also not present a problem if the auditor can remain objective during the audit process and provide a reliable opinion on the company’s financial statements. Recent research (Taylor, DeZoort, Munn, and Thomas, Accounting Horizons, 2003, Issue 3) has argued that auditor reliability should be emphasized by the accounting profession because the fundamental goal of an audit is to provide assurance on the reliability of the financial statements. The authors suggest that auditor independence, integrity, and expertise are all necessary, but are not sufficient conditions for achieving auditor reliability. Even though an auditor’s independence may appear to be compromised, as in the case of a close relationship with management, she can still provide an objective and reliable opinion on the financial statements if she possesses expertise and exhibits strong integrity.
One can argue that other SOA changes have already remediated the closeness problem to a certain extent. For example, the audit committee is now responsible for the appointment, compensation, and oversight of the company’s auditing firm. SOA attempts to enhance the relationship between the auditor and the audit committee at the expense of that between the auditor and management. The audit committee can help by serving as a mediator in financial reporting disagreements between the auditor and management. Indeed, research has found a direct relationship between the strength of company corporate governance (the audit committee) and the quality of its financial reporting.
Staleness and Redundancy
Why audit firm rotation might be the answer. Auditors may become stale and view the audit as a simple repetition of earlier engagements. This staleness fosters a tendency to anticipate results rather than keeping alert to subtle but important changes in circumstances. Auditors returning to an engagement rely on prior-year workpapers to help plan the audit, set the budget, and provide valuable information needed for the current-year audit. Many prior-year schedules are used to develop current-year information. But a problem is created when auditors, especially less-experienced staff, overrely on these workpapers. This problem is likely to be exacerbated when the current-year auditor is reviewing his own workpapers from the prior year. Considerable behavioral research has examined this issue in an attempt to determine if such reliance is a significant problem. The results are mixed, but audit firms have recognized the significance of the reliance on prior workpapers and have taken steps to mitigate this potential problem. Yet, for whatever reason, the great preponderance of high-profile financial reporting failures occurred in circumstances where the audit firm had been engaged for many years.
This staleness in the audit process also affects the auditor’s response to the subjective judgments made by management; that is, repeat audit engagements allow auditors to rely on the judgments of prior auditors in deciding whether a management estimate is in accordance with GAAP. Mandatory audit firm rotation will periodically force new auditors to review management’s representation for compliance with GAAP and may force management to adopt more-conservative accounting practices.
Why audit firm rotation might not be the answer. Having performed the prior-year audit often produces significant benefits that increase audit effectiveness. The familiarity the auditor has with a company provides a better understanding of the issues and a better appreciation for the changes that have taken place from one year to the next. Given the complexity of many of today’s corporations, it is difficult for an auditor to completely understand a company’s business in a short period of time. Audit failure rates have been demonstrated to be higher when the auditors are new and have not yet developed the institutional knowledge necessary for a comprehensive audit. Rotation of personnel on an engagement typically occurs within a firm as individuals receive promotions, retire, or move to other clients.
In addition to the effectiveness issue, returning to a prior engagement also provides added efficiency. The auditor is not starting from scratch, the company is familiar with what the auditor will be asking for, and there is less interruption to normal business. Many carryforward schedules are actually needed as part of the audit, and a new auditor will incur setup costs, even if previous workpapers are made available by a predecessor (e.g., the opening balance in the equipment account). Auditors take up a great deal of a client’s time, creating both a financial and time-saving motivation to have a smooth and efficient audit.
Eagerness to Please the Client
The existence of a long-term “annuity” of possible future audit fees may result in a situation in which the obvious “business decision” is to please the client so as to retain the client. This may be the most compelling argument in favor of audit firm rotation.
Why audit firm rotation might be the answer. With no long-term connection to the client, the auditor does not face a conflict of interest and can act more freely. A recent study (Michael Gibbins, Steven Salterio, and Alan Webb, Journal of Accounting Research, 2003, volume 41, issue 3) states that 67% of the partners from international auditing firms reported that they commonly negotiated with 50% or more of their clients. Can auditors remain independent when doing so may result in the loss of an engagement whose flow of income is potentially long-term? Under mandatory firm rotation, the auditor, the client, and the market all know that rotation will occur on a regular basis. Any deviation from the rotation schedule would likely be received negatively by all interested parties. Mandatory rotation would thereby remove much of the pressure an auditor might experience to negotiate. Knowing that another firm will take over the audit at some known future time increases the concern that the new auditors will detect any oversight, thereby adding to the pressure for the auditor to take a tough stand on any contentious issues. Indeed, research has shown in experimental conditions that the presence of an audit firm rotation policy increases the likelihood of accurate reporting by audit firms.
Mandatory audit firm rotation can also help to address the unconscious desire of the auditor to please the client. Psychological research has long demonstrated that even when people attempt to remain objective and impartial, often they are unconsciously and unintentionally unable to remain impartial, due to a “self-serving bias” that causes them to reach decisions that favor their own interests. With mandatory audit firm rotation, the interest of the auditor does not have to match the interest of the client, thus eliminating the self-serving bias to agree with the client. Indeed, in an experimental audit context, the authors found that rotation did have an impact on the audit process. Due to either a conscious or an unconscious bias, auditors in a nonrotation condition were more likely to agree with the client on a questionable accounting issue than were auditors in the last year of a rotation situation.
Why audit firm rotation might not be the answer. Even with mandatory firm rotation, a temptation remains to keep clients for the entire preestablished rotation period. If a difference of opinion occurs in any but the final year before rotation, there is the potential for losing the client “prematurely.” Under mandatory audit firm rotation, auditors have the rotation period to make income. Any auditor with a short-term emphasis might be under even greater pressure to avoid losing the client. Thus, even with firm rotation, both a conscious and a subconscious desire to please the client during the rotation period can affect the audit process.
In addition, one may question the quality of service in the final year of the audit because the audit firm may be less motivated to serve a “lame-duck” client. Firms have already indicated that they would likely move their best and most experienced partners away from such clients, which could increase the probability of an error in the audit. Mandatory firm rotation will also require companies to select a new auditor, which in itself may lead to opinion-shopping in deciding which firm to hire.
The Position of Accountancy Institutions
The businesses that provide audits seem uniformly against required firm rotation. For example, Accountancy Age (September 1, 2003) reported that 20 of 21 firms responding to a survey were against mandatory firm rotation.
The AICPA, which historically has represented audit firms in federal hearings, both currently and historically, has opposed mandatory audit firm rotation, arguing that it will increase rather than decrease the number of audit failures. These arguments generally cite the statistics indicating higher than average audit-failure rates in the first years of an audit relationship.
The recent GAO study on audit firm rotation also reported that auditor tenure does not affect the manner in which auditors deal with material financial reporting issues. A GAO survey found that approximately 69% of the Tier 1 CPA firms (10 or more public clients) and 73% of the Fortune 1000 public companies surveyed did not believe long-term auditor relationships increase the risk of audit failures. Yet, 38% of these CPAs and 65% of the Fortune 1000 company respondents acknowledged that investor perceptions of auditor independence would increase under mandatory audit firm rotation. These two groups also indicated, however, that the costs of mandatory audit firm rotation would exceed the benefits.
The issue of audit firm rotation has not been limited to the United States, and considerable insight can be gathered from non-U.S. countries. Several countries (e.g., Spain, Turkey) have adopted and subsequently dropped mandatory audit firm rotation because it did not achieve public policy goals. In Italy, the Bocconi University Report concluded that audit firm rotation, which is mandatory in Italy, is detrimental to audit quality but does seem to have a positive effect on improving public confidence in the corporate sector.
Unanswered Questions
The net effect of audit firm rotation is uncertain. On the one hand, it is bothersome that auditors placed in a situation where no rotation is expected are more likely to agree with a client on a difficult accounting issue. Logically, an expected long-term stream of audit fees could also result in different decisions, due to either conscious or subconscious reasons. Despite these considerations, the research indicating high first-year audit failure rates suggests that rotations might result in auditors with higher perceived independence performing lower-quality audits. Many other potential effects of mandatory audit firm rotation remain unmeasured. For example, how will a much larger annual supply of possible new audit clients affect auditors? Will marketing ability trump technical competence in winning new engagements? Would CPAs staff their audits differently toward the end of the rotation period? In addition, there is no information on likely changes in the costs of audits due to rotation.
Even the high audit failure rates in the early years of an engagement are uncertain. Under mandatory rotation, would the increased number of first- and second-year audits lead to a higher level of auditor skill in these circumstances and to a lower level of audit failure? Or, could a closer working relationship with the predecessor auditor limit early-year audit failures?
Another issue relates to audit firms themselves. Given that the Big Four handle the bulk of the large publicly held corporations, will rotation involve only these four firms? Are non–Big Four firms able or willing to handle large SEC audits? Will audit firm incentives to specialize in specific industries be diminished because the possible future benefits do not outweigh the current costs of training auditors? Anecdotal evidence suggests that the Big Four will gain greater market share if rotation is mandatory, which will lead to a less competitive environment without addressing the related policy issues. Less competition will probably lead to substantially higher audit fees—firms estimate that first-year fees would increase by more than 20%—and significantly higher costs for companies. (Estimates are that the additional costs associated with selecting and assisting new auditors are at least 17% of a company’s current audit fee.)
The idea of enhancing auditor independence through mandatory audit firm rotation appeals superficially to many, yet the net effects of rotation are far from certain. The impact of SOA reforms is not yet known. Safeguards are now in place to address many of the key concerns relating to the independence and objectivity of the audit firms. In addition, companies and their top management are taking a more active role in oversight of the system in place to prepare accurate financial statements and prevent abuse. Experience and further research related to both audit firm rotation and these changes may lead to a more informed decision on mandatory audit firm rotation than is now possible.
Barbara Arel, CPA, is a doctoral student at the W.P. Carey School of Business, Arizona State University, Tempe, Ariz.
Richard G. Brody, PhD, CPA, is an associate professor at the College of Business, University of South Florida, St. Petersburg. Kurt Pany, PhD, CPA, is a professor at the W.P. Carey School of Business.
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