Analysis of Mandatory Firm

Rotation

PART I: INTRODUCTION

The imposition of adopting mandatory audit firm rotation has been

considered previously in the United States by several bodies. In general, the

idea of auditor term limits was mentioned in 1977 at Metcalf hearings, due to

the Penn Central Crash. More recently, mandatory rotation was included in a

bill that was introduced in the Senate Commerce Committee in 1994. Yet,

prior to the introduction of the Sarbanes-Oxley Act (SOX), it was commonly

accepted that it was more beneficial for public firms to retain the same

auditing firm on a long term engagement basis.

Subsequent to the collapse of world famous Scandals such as Enron and

WorldCom during late 1990s and early 2000s, Congress passed Sarbanes-

Oxley Act of 2002 as a way to enhance audit quality and restore investor

confidence in capital market. Particular attention has been given to the

aspects of the long term auditor-client relationship that could impact on

auditor independence. Therefore, global legislators and regulators were

compelled to discuss the limits on auditor tenure. Regarding the audit

rotation, there are two types of restriction which are firm rotation and

partner rotation. Firm rotation is to restrict the length of time that an audit

firm can serve for a specific public firm whereas partner rotation is to switch

the key audit personnel such as engagement partner periodically.

On Aug 16th, 2011, from the comment letters 121-day exposure period, the

Public Company Accounting Oversight Board (PCAOB) voted to issue a

concept release to solicit public comments on the feasibility of proposed

standard setting projects on means to enhance auditor independence,

objectivity, and professional skepticism, including through the adoption of

mandatory firm rotation policy. According to the Chairman of PCAOB, Doty

stated, the reason to adopt mandatory audit firm rotation is because audit

term limits would enforce a registered public accounting firm to serve as the

auditor of a public company in a limited numbers of consecutive years so as

to protect the independence and objectivity of audit quality in terms of

reducing the pressure of long-term engagement relationship to the detriment

of investors and capital markets. From the comment letters, the proponents

of audit firm rotation believe that compulsory rotation would prevent

auditors from being aligned with manager, which in turns enhance auditor

independence. Also, audit firm rotation would help to restore investor

confidence in the regulatory system in addition to prevent large-scale

corporate collusion

On the contrary, opponents declared that limits on audit tenure will not only

diminish audit quality, resulting from a significant learning curve with new

clients, but also create significant switching cost and “start-up” cost.

Although it is hard to obtain empirical evidence on the costs and benefits of

mandatory rotation before its implementation, experimental studies were

conducted to examine the feasibility of audit rotation. For example, SOX

required the U.S. Government Accountability Office(GAO) to study the

potential effects of requiring public companies registered by the SEC to

periodically rotate the public accounting firms they retain to audit their

financial statements. The result indicated that the benefits from imposing

mandatory audit rotation during a periodic time were insufficient to cover

switching and other relevant costs that would be incurred by audit firms and

their clients. (GAO [1996]).

In addition, the concept release invited commenters to respond to specific

questions, including, the discussion of other alternatives to mandatory

rotation that the board should consider in order to further enhance auditor

independence, objectivity, and professional skepticism. For example, joint

audits allow two or more auditors to produce one single audit report, thereby

sharing responsibility for the same audit. Also commenters suggested that

audit committee could solicit bids on the audit after a certain number of

years with the same auditor.

In reality, mandatory audit firm rotation has been adopted by several foreign

countries. Spain had adopted the mandatory audit firm rotation policy since

1988 which enforced audit firms to serve a public company with no less than

three years and no longer than nine years. However, this policy was removed

in 1995, and allowed audit firm to renew an audit contract on a yearly basis

as long as the initial contract expired.Currently, listed public firms in Italy

and Brazil are required to rotate their external auditor every nine and five

years, respectively. Australian government mandate the periodic rotation of

lead audit partners although there is no legislative requirement for public

firms to rotate their independent audit firm.

The issue of mandatory firm rotation has been debated on and off for

decades. The purpose of this report is to demonstrate the benefits and

drawbacks of adopting mandatory firm rotation policy from a neutral

standpoint of view. The remainder of the paper proceeds as follows. In part II

and part III, we will discuss the key advantages and disadvantages of

mandatory firm rotation along with supported evidences, respectively. In

part V, we will provide the possible implementation procedures and

summarize key issues audit firms should face after adopting mandatory firm

rotation.

PART II : ADVANTAGES OF MANDATORY FIRM ROTATION

The collapse of some large-scale corporations, such as Enron, Tyco, and

WorldCom, indicates that the long-term relationship between auditors and

clients may negatively impact auditors’ independence. It is estimated that

the overall market capitalization of these corporations is about $US460

billion, and investors’ confidence on audited financial statement was heavily

impaired. Firm rotation is one way to restore investors’ confidence. As all we

know, auditors economically rely on the fees paid by clients. Once auditors

build a solid relationship with clients in a comparative long time of period, it

is reasonable to question that whether they are willing to challenge

managers’ assumptions as frequently as they should.

Firm rotation will enhance auditors’ independence and objectivity. The

AICPA’s code of Professional conduct heavily emphasizes the importance of

auditors’ independence and objectivity. The value of auditors is to express

an opinion on clients’ financial statements. By considering auditors’ opinion,

investors and other stakeholders could decide whether they should rely on

financial statements to make sound investment or other decisions. Research

shows that a company is more likely to retain its auditor when the auditor

gives the company a clean opinion, compare with the situation where there

is a disagreement between the auditor and its client (Antle and Nalebuff

1991). Thus, if auditors are lack of independence and objectivity, they may

be in favor of management’s position and issue bias opinions. Without

auditors serving as a watchdog, managers may deliberately issue financial

statement containing false, fraudulent, deceptive or misleading information

to maximize their own interest. Firm rotation mandatorily requires public

firms to retreat from engagement of certain clients if they consecutively

audit those clients for certain number of years. Therefore, firm rotation

substantially increases the independence of a whole firm，and auditors have

more freedom to challenge managers’ suspicious assumptions without

considering the possibility of losing clients by the whole firm in the long run.

Firm rotation could allow a “fresh look” at the organization. Once an auditor

has been dealing with a client for a long time, the auditor may become too

familiar with the business model and organization structure of the client.

Therefore, the auditor is more willing to repeat the similar audit procedure

year by year without any substantial change. Since professional judgment is

required in many audit works, a new audit team from other firm may view

the company’s financial reporting system, internal control, business risk and

other related factors from a different perspective. Ellen Seidman (2001),

Director of the office of Thrift supervision, who opined that audit firm rotation

every 3-4 year was desirable, in that it would allow a “fresh look” at the

organization. Similarly, nonregulatory bodies such as the Conference Board

(2003) suggested the need for firm ration as well.

Mandatory firm rotation has been advocated to overcome the collusion

problem. It is highly possible that auditors and managers will build friendship

after certain period of time. In this case, auditors may facilitate managers to

engage in some fraudulent activities, the case of which has happened in

Enron. Since firm rotation frequently bring auditors from other firms in to

substitute the old auditors, the collusion between managers and auditors

become a very hard task.

PART III DISADVANTAGES OF MANDATORY FIRM ROTATION

According to the analysis above, firm rotation is considered to have the merit

of enhancing auditor independence, objectivity, and professional skepticism.

However, we have to admit the fact that there are currently no requirements

for mandatory audit rotation on audit engagements, which should be treated

as a signal that there must be some problems associated with it. Regarding

to the limited academic research, the potential problems caused by

mandatory audit firm rotation could overweight the benefits it brings. We

would analyze the problems from the cost, audit quality and expertise, and

then we would use a real case of mandatory firm rotation in Spain to

demonstrate our analysis.

Audit Cost

The first problem that associates with the mandatory firm rotation is the

increase of the audit cost.

First of all, the mandatory firm rotation would lead to a loss of client

knowledge when the auditor is forced to resign. Audit costs would rise due to

the additional work needed by the new audit firm. The principal star-up costs

borne by the auditor involve familiarization with the client’s accounting

procedures and checking the initial balance sheet figures. According to a

survey conducted by the General Accounting Office (GAO), almost all large

public accounting firms (those with 10 or more audit clients) said that initial

year audit cost would go up by more than 20 percent over the subsequent

years audit cost to allow the new audit firm to acquire the necessary

knowledge of the audit client. Moreover, audit firms might stop the

consistently audit fees discount for new engagements to cover the increased

costs.

For the audit committee and management team, additional time and cost

would occur because of the frequency changes of audit firms. The audit

committee will have to focus on choosing a new qualified auditor, which

would distract them from pay attention to the quality of internal controls and

financial information. Mandatory for rotation would also damage the

effectiveness of the audit committee regarding the selection of the best

audit firm that satisfied the company needs, since there is a mandatory

rotation. Management team will also spend more time and effort with new

auditors to educate team on the company’s operations and financial

frameworks. The overdo of work by the audit committee and management

would also add the financial burden of the client companies.

Investors would also bear the cost of the mandatory firm rotation. The

opportunity costs would increase by a mismatch between the client’s needs

and the auditor’s offers. Under voluntary rotation, the auditor resignation

serves as a signal that a client is experiencing conflicts with its auditor over

accounting treatments and the auditor is forced to rotate. The mandatory

rotation would wipe out this kind of valuable signals, which may mislead

investors to make the accurate decision.

Another factor to consider is that audits may go up for bid more often.

According to Cohen Commission, fees and budgets are serious concerns by

putting auditors in situations in which new clients are up for bids more often.

Under this circumstance, the mandatory firm rotation would put large audit

firm in better situation, since they are better at bidding on new clients. If

large audit firm are capable of obtaining more new clients because of their

effective bidding and market influences, the end result could be even more

market concentration than we currently have.

Independence and Audit Quality

One of the major argue about the benefit of mandatory audit firm rotation is

that it could improve the audit quality by increase the competence and

independence of audits firms, which could improve the confidence of the

market. However, findings of Jackson State University based on 212 useable

responses indicate that loan officers do perceive an increase in

independence when the company follows an audit firm rotation policy. The

length of auditor tenure within rotation fails to significantly change loan

officers’ perceptions of independence. Findings also indicate that neither the

presence of a rotation policy nor the length of the auditor tenure within

rotation significantly influences the loan officers’ perceptions of audit quality.

Actually, several academic studies have showed that investors do not think

audit firm rotation improves the overall quality of audit. On the other hand,

they think different auditing practice and procedure by different audit firm

cause mislead and confusion about the company’s financial reporting.

Some opponents of mandatory rotation argue that audit market provides

strong economic and institutional incentives for auditor independence,

making mandated rotation unnecessary. According to them, auditors’

incentives to protect firm reputation have more importation role in

maintaining auditor independence and audit quality. According to a research

by Krishnan and Krishnan 1996, the loss of reputation caused by audit failure

could severely impact the future business and value of the audit firm. This

fear of losing reputation is strong enough to prevent the fraud of the audit

firm with their clients, which makes the mandatory rotation unnecessary.

Further, some recent studies show that such incentives seem to have more

influence if there is no man datary rotation, which means, instead of improve

audit quality, mandatory rotation may even do more harm. Market-based

incentives may be more effective in safeguarding auditor independence.

Another problem is that frequently rotation could cause some potential risk

to audit quality. COSO 1987 suggests that a significant number of financial

fraud involved companies that had recently changed their auditor. Some

other studies suggest that a greater proportion of audit failure occur on

newly acquired audit clients. Quality control inquiry committee of SEC

suggests that from 406 cases of alleged auditor failures between 1979 to

1991, audit failure occurred almost three times more often when the audit

firm was engaged in its first or second year. The client seems to easy fraud

the auditor since they do not have adequate knowledge about the company

yet.

Expertise and competition

Usually, different audit firm has its own set of practices and auditing

procedure. Specific domain experience and knowledge could help the audit

firm to maximum the audit firm’s performance and profit. Craswell et al.

(1995) find that industry-specialists command a fee premium of around 16

per cent over non-industry specialists, indicating that clients are willing to

pay more for the services of such an auditor. Also, experience auditors are

less likely to be influenced by the irrelevant information in their judgments

(Ghosh and Moon 2005). However, mandatory rotation could damages audit

firms’ incentive to build their specialization, since the clients have to change

the audit no matter the performance of the audit firm. From a dynamic

perspective, given that it substantially reduces the incentive to invest in

specialized resources, the rule will lessen the future degree of specialization,

and thus the level of auditor competence.

Another problem need to be considered is that many companies, especially

the large ones, trend to have limited number of audit firms to choose

regarding to the ability and scale of the audit firm. Independence rules

further restrict the choice of accounting firm that provide non-audit services.

If rotation were required, the company's choice of a new auditor might be

limited unless it terminated existing prohibited non-audit services, which it

might not be able to do in a timely manner.

PART IV: SUMMARY

We have discussed whether auditor independence, objectivity and profession

skepticism would incrementally be influenced by mandatorily rotating audit firm.

Sarbanes-Oxley Act has provided a variety of initiatives to enhance independence,

audit quality and restore investor confidence in the capital market. On one hand,

mandatory firm rotation, to some extent, could lessen economic incentives

associated with compromised independence. However, on the other hand,

mandatory rotation would increase audit fees, increase audit competition, and lose

audit specialization.

Possible approaches after adopting mandatory firm rotation

As we learned with the comment letters on Exposure Drafts, appropriate term

length after the firm rotation adoption would be long enough to recover the start-up

costs, but less than ten years. In addition, various term length depending on the

size of audit engagement relative to the size of audit firms. There properly would be

a learning curve before auditor can become effective on the new engagement with

new clients. Furthermore, audit firms concern firm rotation between audit and non-

audit services.

Audits could become much less client-specific than the current audits and more

targeted to apply to larger groups of clients in order to minimize switching costs

resulting from mandatory firm rotation. By the same token, auditors may have to

become much more generalist than specialist in nature if their audit firms do not

focus on a particular industry, which would easily reallocate resources across clients

in the same specialty or industry. However, SEC and FASB have always brought

about the necessity for audit specialists who have detailed understanding of client’s

industry and business operations to ensure the compliance of regulations and

adherence of financial reporting requirements. Furthermore, after adopting

mandatory firm rotation, more supervision and oversights would be needed for the

first two or three years of new engagement dealing with new clients. There would

be increased communications, which could be mandatory as well, between the

predecessor and current auditors.

Inevitably, audit firms would spend tremendous amount of time and resources

accepting a new client, balance the high audit budget and cost to cover the

payback period during the audit tenure, and seek potential clients to maintain

market concentration.

Possible alternatives to mandatory rotation

Audit firms, board of directors, audit committees and other stakeholders have been

considering alternatives that would meaningfully and effectively enhance auditor

independence, objectivity, and professional skepticism.

First, joint audit, in which client is audited by two or more auditors from different

audit firms to produce a single audit report, thereby sharing responsibility for the

audit. Work performed by each auditing group is reviewed by the other, in most

cases by exchanging audit summary reports. There would be a joint report provided

to the management, audit committee, and general public. Audit committees and

investors would have additional assurance that the audit report. A joint audit is

likely to mitigate the risk of over familiarity. Two audit groups would stand stronger

together against aggressive accounting treatments and enhance professional

skepticism and objectivity. Consequently, joint audit could effectively maintain and

improve audit quality

Second, continuous oversight the audit quality and auditor’s independence by audit

committee: audit committee would continue to address concerns about

independence, objectivity, and professional skepticism through oversight and

inspection to achieve the similar results without implementing a costly approach as

mandatory firm rotation. Oversight could focus on incentives that audit partners

may have relaxed professional skepticism.

Third, requirements for the audit committee to solicit bids on audit after a certain

number of years with the same auditor: Market based incentives, such as soliciting

bids on new auditors with current auditors, would be more effective in safeguarding

auditor independence than regulatory measures such as rotation.

Conclusion

Even though there is no empirical evidence of adopting mandatory firm rotation in

US, what we learned from Spain’s adoption from 1988 to 1995 no evidence

suggests that mandatory firm rotation is associated with the propensity for auditors

to issue qualified audit opinions. Furthermore, there is no association between the

so called economic dependence and likelihood of issuing a biased report in both

mandatory rotation and post mandatory rotation period.

Nowadays, however, numerous researchers have argued that audit firm rotation

make auditors appear to be more independent. Auditor independence may be

adversely affected by long term relationship and the desire to retain current clients

(GAO 2003). Mandatory firm rotation, to some extent, has been advocated to

overcome the collusion problem. In a regime without mandated rotation, auditors

are more likely to issue biased reports because of the economic dependence.

Inevitably, there are some incentives drive auditors to keep independent, objective

and professional skepticism, such as the market-based incentives and reputation

protection. Market-based incentive may safeguard audit quality as well as enhance

auditor independence. Auditors’ reputation is positively associated with the ability

to earn higher fees and attract clients (Defond et al 2002). Loss of reputation

caused by the audit failure would impose significant cost and further lose clients

and reduce revenue; thus, the reputation protection can effectively prevent risk of

collusion and bias consequently enhance auditors’ independence, objectivity and

professional skepticism.

PART V REFERENCE

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