Accounting Research Journal

Audit firm rotation and audit quality: evidence from academic research
David S. J enkins Thomas E. Vermeer
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To cite this document:
David S. J enkins Thomas E. Vermeer, (2013),"Audit firm rotation and audit quality: evidence from academic
research", Accounting Research J ournal, Vol. 26 Iss 1 pp. 75 - 84
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http://dx.doi.org/10.1108/ARJ -11-2012-0087
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Users who downloaded this article also downloaded:
Andrew B. J ackson, Michael Moldrich, Peter Roebuck, (2008),"Mandatory audit firm rotation and audit
quality", Managerial Auditing J ournal, Vol. 23 Iss 5 pp. 420-437
Sandra K. Gates, D. J ordan Lowe, Philip M.J . Reckers, (2006),"Restoring public confidence in capital
markets through auditor rotation", Managerial Auditing J ournal, Vol. 22 Iss 1 pp. 5-17
Ali Abedalqader Al#Thuneibat, Ream Tawfiq Ibrahim Al Issa, Rana Ahmad Ata Baker, (2011),"Do audit
tenure and firm size contribute to audit quality?: Empirical evidence from J ordan", Managerial Auditing
J ournal, Vol. 26 Iss 4 pp. 317-334
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Audit rm rotation and audit
quality: evidence from
academic research
David S. Jenkins and Thomas E. Vermeer
Department of Accounting & MIS, University of Delaware,
Newark, Delaware, USA
Abstract
Purpose The purpose of this paper is to provide a succinct overview of academic research that has
examined audit rm rotation both in the USA and in other countries.
Design/methodology/approach The authors outline the unresolved nature of academic research
on audit rm rotation, review recent literature, discuss why academics have been unable to resolve this
issue and offer suggestions for improving subsequent research in the area.
Findings Overall, the collective evidence is inconclusive at best; with earlier studies generally
nding mixed results and more recent studies indicating that audit quality generally goes through two
distinct phases during the auditor-client relationship, the auditor learning and auditor closeness
phases.
Originality/value Given the importance of the issue, this article provides an overview of academic
research that has examined audit rm rotation, discusses why academics have been unable to resolve
this issue, and provides suggestions on how academics and practitioners can work together to enhance
the quality of future research.
Keywords Accounting research, Auditing, Auditor tenure, Auditor-client relationship,
Mandatory auditor rotation
Paper type Literature review
Introduction
Audit rm rotation as a means of enhancing auditor independence has been scrutinized
and debated by accounting regulators, practitioners, and academics for decades. Most
recently, the US Congress strongly considered such a policy in drafting the
Sarbanes-Oxley Act (SOX), but instead settled in favor of mandating ve-year partner
rotation. The issue was formally resurrected again in August 2011, when the US Public
Company Accounting Oversight Board (PCAOB) issued a concept release to solicit
comments on mandatory audit rm rotation, with the PCAOB particularly interested in
audit terms of ten years or greater ( JOA, 2011). As suggested in the concept release,
there is much disagreement regarding the viability/merits of audit rm rotation.
On one side, investors are generally in favor of a rotation requirement as a powerful
antidote to auditor conicts of interests which they believe will signicantly diminish
the incentives of auditors to placate management and will provide a needed fresh look
(PCAOB, 2011). In contrast, the business community generally believes it carries
signicant increased audit costs, undermines the role of the audit committee, decreases
the quality of audits, and potentially increases the likelihood of opinion shopping
(AICPA, 2011; IIA, 2012; PCAOB, 2011)[1].
Regardless of the outcome of the US PCAOB concept release process, audit rm
rotation for public companies is not new and will continue to be a topic of public debate
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1030-9616.htm
Accounting Research Journal
Vol. 26 No. 1, 2013
pp. 75-84
qEmerald Group Publishing Limited
1030-9616
DOI 10.1108/ARJ-11-2012-0087
Audit rm
rotation
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for years to come. In addition, the PCAOBs discussions may trigger states
governments within the USA to consider audit rm rotation for nonprots and public
companies may consider voluntary audit rm rotation as a positive signal to the
nancial markets[2]. Given the importance of this issue, this article:
.
discusses the regulatory background of audit rm rotation in the USA and other
countries;
.
provides an overview of academic research that has examined audit rm
rotation;
.
discusses why academics have been unable to resolve this issue; and
.
provides suggestions on how academics and practitioners can work together to
enhance the quality of future research.
This overview should be useful to practitioners as they discuss this issue within their
rms, with their clients, and the larger business and investor communities.
Regulatory background of audit rm rotation in the USA and other
countries
USA
For more than 35 years, US regulators have considered a regulatory limitation on audit
rm tenure. In 1977, the US Senate Committee on Government Operations, Chaired by
Senator Metcalf, published the Metcalf Report. In this report, the Committee noted that
a long association between an audit rm and a client may lead to such a close
identication of each interest that truly independent action by the audit rm becomes
difcult. The report further noted that:
[. . .] one alternative is a mandatory change of accountants after a given period of time, or after
any nding by the SEC that the accounting rm failed to exercise independent action to
protect investors and the public (Metcalf Report, 1977).
In the following year, the American Institute of Certied Public Accountants
Commission on Auditors Responsibility, better known as the Cohen Commission,
reached a different conclusion regarding audit rm rotation. The commission
recommended against mandatory audit rm rotation because the:
[. . .] cost of mandatory rotation would be high and the benets that nancial statement users
might gain would be offset by the loss of benets that resulted from a continuing relationship
(Cohen Commission, 1977).
Instead, the Cohen Commission recommended that the audit committee is in the best
position to determine when rotation is appropriate.
The issue of mandatory audit rm rotation in the USA was fairly dormant until late
2001. In fact, the Treadway Commission, a private-sector initiative of the American
Institute of Certied Public Accountants, American Accounting Association, Financial
Executives Institute, Institute of Internal Auditors, and National Association of
Accountants, issued the Report of the National Commission on Fraudulent Financial
Reporting in 1987. In this report, the commission did not address mandatory audit rm
rotation; rather it recommended that audit rms should recognize and control the
organizational and individual pressures that potentially reduce audit quality. Further,
in 1994, the SEC was commissioned by US Congress to study auditor independence
ARJ
26,1
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and provide any recommendations for legislation. In this staff report, the SEC indicated
that the professions requirement for a periodic change in the engagement partner in
charge, especially coupled with the requirement for second partner reviews, provides
a sufcient opportunity for bringing a fresh viewpoint to the audit without creating the
signicant costs and risks associated with changing accounting rms that were
identied by the Cohen Commission (SEC, 1994).
In late 2001, with the failure of Enron, WorldCom, and Global Crossing, the issue of
mandatory audit rm rotation was once again formally considered by regulators.
In fact, the US Congress strongly considered such a policy in drafting the SOX, but
rather asked the US General Accounting Ofce (GAO) to study the potential effects of
mandatory audit rm rotation. The GAO issued its report in 2003 suggesting that
several years experience with the implementation of SOX is needed before determining
if additional requirements are necessary to enhance auditor independence and audit
quality. In 2011, the PCAOB issued a concept release seeking comments on mandatory
audit rm rotation, given that sufcient time had passed since the implementation of
SOX and several hundred cases involving what they determined to be audit failures
were discovered during annual inspections of the largest audit rms for eight years.
Australia
Besides the USA, other countries are considering mandatory audit rm rotation.
In December 2012, Greg Medcraft, Chairman of the Australian Securities and
Investment Commission, noted that they found a 30 percent increase in the failure of
auditors to detect material misstatements in public company nancial statements for
the 18 months ended June 30, 2012. Given this deterioration, Mr Medcraft noted that he
will recommend mandatory audit rm rotation to the Australian Government if
standards drop further, to strengthen the present requirement that audit partners
change every seven years (Durkin, 2012).
Europe
Similar to Australia, the European Union (EU) is also concerned with auditor
independence. Following the EUs three billion bailout of banks during the credit crises,
Michael Barnier, Internal Markets Commissioner of the European Commission,
suggested that mandatory audit rm rotation would boost the quality of audit,
shattering the perverse pressure on partners not to lose long-standing clients
(Orlik, 2011, p. 1). Mr Barnier further noted that auditor independence is neither assured
nor demonstrable, and infrequent rm rotation has deprived audit of its ethos:
professional skepticism (Orlik, 2011, p. 1).
Academic research examining audit rm rotation in the USA
Since audit rm rotation is generally not required in the USA, academic research
examining audit rm rotation in the USA has been primarily limited to an environment
of voluntary auditor changes. Further, since companies change auditors rather
infrequently in the USA, many studies addressing mandatory rotation have examined
whether and how the duration of the auditor-client relationship (i.e. auditor tenure)
affects the quality of audits. Although these auditor tenure studies do not directly
examine mandatory audit rm rotation, Carey and Simnett (2006) suggest that auditor
tenure studies do examine the fundamental underlying objective of mandatory audit
Audit rm
rotation
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rm rotation, i.e. that after a long period of tenure, continuing relationships between
a client and audit rm may impact a rms independence, and time may deteriorate
a rms ability for critical appraisal. Thus, researchers suggest that the results from
auditor tenure studies can shed light on the efcacy of a policy of mandatory audit rm
rotation to increase audit quality.
Given that audit quality is generally unobservable from publicly available
information, researchers have developed proxies for audit quality. These proxies have
focused on either nancial statement measures such as material misstatements (Carcello
and Nagy, 2004), discretionary accruals ( Johnson et al., 2002; Gul et al., 2007), and
restatements (Myers et al., 2003); or audit reporting failures (Geiger and Raghunandan,
2002) (Table I)[3]. In addition to examining proxies for audit quality, researchers have
also examined the effects of audit rmtenure froman investor perspective. Specically,
these studies have examined whether a relationship exists between audit rm tenure
and the cost of borrowing (Mansi et al., 2004), earnings response coefcients (Ghosh and
Moon, 2005), and equity risk premiums (Boone et al., 2008) (Table II)[4].
Earlier studies on voluntary rotation generally model the relation between auditor
tenure and audit quality as a linear relation, such that audit quality either strictly
increases or decreases (or has no relation) over time, and have generally found mixed
results. More recent studies have allowed for the possibility of a nonlinear relation. For
example, Boone et al. (2008) examine the relation between auditor tenure and
client-specic equity risk premiums and document a nonlinear relation. Specically,
they nd that the equity risk premium initially decreases as tenure increases, but for
long tenures the equity risk premium increases with additional years of tenure.
Meanwhile, Davis et al. (2009) nd a similar nonlinear relation and demonstrate that
clients of short and long tenure auditors are more likely to use discretionary accruals to
meet or beat earnings forecasts relative to clients of medium tenure rms. In a similar
vein, Jenkins and Velury (2008) examine the relation between auditor tenure and
reporting conservatism and report similar ndings.
Ingeneral, these nonlinear studies indicate that audit quality generallygoes through
two distinct phases during the auditor-client relationship. During the early years referred
to as the auditor learning phase, auditors become more familiar withthe client andaudit
quality tends to improve. Then, at some point when the relationship reaches a certain
threshold referred to as the auditor closeness phase, audit quality begins to deteriorate
as the auditor presumably becomes more complacent and experiences greater challenges
to objectivity and independence. This demonstrated nonlinearity likely explains the
mixed results found in earlier studies; however these recent ndings get us no closer
to resolvingthe mandatoryrotationissue as the results indicate that there maybe merit to
both sides of the argument.
Academic research examining audit rm rotation outside the USA
Although academic studies in the USA have been primarily limited to voluntary
auditor tenure studies, academic researchers have examined audit rm and partner
rotation in other countries, such as Australia, China, Korea, Spain, and Taiwan, where
mandatory rotation is required to different extents. Kim and Yi (2009) examine the
impact of audit rm tenure on audit quality in Korea where mandatory audit rm
rotation is required for problematic rms[5]. The authors nd that rms with
mandatory auditor changes report signicantly lower discretionary accruals compared
ARJ
26,1
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Table I.
Audit quality measures
as operationalized in
audit rm tenure studies
Audit rm
rotation
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to rms with voluntary auditor changes, suggesting that mandatory audit rm
rotation improves audit quality. In contrast, Firth et al. (2012) examine the impact of
both mandatory and voluntary audit rm rotation under different regulatory
environments in China. Using an auditors propensity to issue a modied audit opinion
as a proxy for audit quality, Firth et al. (2012) nd that mandatory audit rm rotation
has a limited impact on audit quality, with the effect restricted to rms located in less
developed regions.[6]
Although Australia currently does not have mandatory audit rm rotation,
Australia provides a unique experimental setting for academic researchers because,
unlike the USA, Australia requires that the lead auditor personally sign the audit
report, hence allowing researchers to track changes in the audit partner from year to
year. Using this unique setting, Carey and Simnett (2006) examine the association
between audit quality and long audit partner tenure in Australia. The authors nd
a lower propensity to issue a going concern modied opinion and some evidence of just
meeting or missing earnings benchmarks for long tenure observations; suggesting that
audit quality deteriorates with long partner tenure[7]. Ryken et al. (2007) also examine
the rotation practices before and after the implementation of mandatory rotation of lead
and audit review partners in Australia. The authors nd that the introduction of
mandatory rules after 2005 signicantly reduced the incidence of long partner tenure;
with auditors in locations outside Australias three major cities more likely to have
longer audit partner tenure than those located in the major cities. The authors suggest
that Australia should consider the need for reasonable exemptions to mandatory
rotation requirements given the higher costs of partner rotation to smaller rms and to
rms in remote locations. Given that the lead auditor must personally sign the audit
report in Australia, Chapple and Hossain (2011) also examine the Australian
experience with the mandatory audit partner requirements. The authors nd that
58 percent of Australian companies had to change the lead audit partner because of the
mandated change after 2005 and this change impacted Big 4 and non-Big 4 audit rms
fairly equally. Overall, similar to studies of rms in the USA, collective evidence from
international studies on audit rm and partner rotation is inconclusive at best.
Publication Auditor tenure variable
Investor perception
measure
Academic operationalization
of investor perception measure
Mansi et al.
(2004)
Audit rm tenure (number of
consecutive years the rm has
retained auditor)
Cost of borrowing Cost of debt (interest rate on
debt capital) and/or debt
quality (debt rating from
ratings agencies)
Ghosh and
Moon (2005)
Audit rm tenure (number of
consecutive years the rm has
retained auditor)
Earnings response
coefcient (ERC)
Estimate of the change in a
companys stock price from
the information provided in its
earnings announcement
Boone et al.
(2008)
Audit rm tenure in both
years and years
2
(nonlinear
model)
Equity risk premium The excess return that an
individual stock provides over
a risk-free rate, with the size of
the premium positively
varying with the risk in a
particular stock
Table II.
Investor perception
measures as
operationalized in audit
rm tenure studies
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Future direction
Given the unresolved nature of academic research on audit rmrotation both in the USA
and internationally, the logical next step is to examine where to go from here. In order to
do so, it seems prudent to discuss why existing research has been unable to resolve the
issue. First, as noted previously, audit quality is not directly observable and has largely
been measured by various characteristics of reported earnings and/or investor
perceptions. While necessaryto this point because of datalimitations, doingso introduces
measurement error to the models as a varietyof factors, outside of audit quality, canaffect
earnings characteristics and investor perceptions. Second, while the literature has
identied important auditor characteristics, such as auditor learning and auditor
closeness which are purported to affect audit quality, a much better understanding of
how these qualities manifest in audit quality is needed. The complex nature of the
auditor-client relationship requires a ner measure to capture these qualities than simply
the number of years an auditor has audited a particular client[8]. Finally, and most likely
due to data and measurement limitations, existing research has focused almost
exclusively on evaluating the potential benets/detriments of audit rmrotation on audit
quality. Little to nothing substantive has been done to balance these audit quality effects
with associated costs of switching auditors, which has been the primary argument used
to refute the merits of a policy of mandatory rotation.
We believe the common element that can help solve these weaknesses is increased
input from practitioners. For example, advanced behavioral studies with more
knowledgeable subjects (i.e. experienced practitioners) could compensate for limitations
regarding observable audit quality[9]. In addition, input from practitioners related to if
and howauditor tenure manifests in auditor characteristics such as auditor learning and
auditor closeness could provide better model specications than simply counting the
number of consecutive years an auditor has audited a client. Finally, practitioner input
regarding the identication and measurement of costs associated with auditor rotation
could help balance current research that is focused on benets/detriments of rotation on
audit quality.
Summary and conclusion
Overall, we feel that existing research and related policy decisions on audit rm
rotation have reached an impasse. To create more clarity on this issue and move
toward a policy resolution, future research needs to be enhanced. With that, the
purpose of this paper is to highlight the research to date, stimulate dialogue between
academics and practitioners, and elicit more involvement of practitioners to enhance
the quality of future research on audit rm rotation.
Notes
1. Interestingly, there are dissenting views even among the members of the PCAOB on
the merits of mandatory rotation (Wyatt, 2011), further illustrating the unsettled nature of
the issue.
2. This would be consistent with the approach that state governments within the USA have
taken with applying SOX-type provisions to nonprots.
3. See Table I for a description of the various denitions of audit quality as operationalized in
audit rm tenure studies.
Audit rm
rotation
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4. See Table II for a description of the various denitions of investor perception of audit quality
as operationalized in audit rm tenure studies.
5. The Korean Financial Supervisory Commission, equivalent to the SEC in the USA, denes
a problematic rm as one with high agency problems (e.g. insufcient separation of
ownership and management), nancial problems (e.g. excessive reliance on debt and
industry restructuring), questionable auditor changes, and/or GAAP violations in annual
reports.
6. Ruiz-Barbadillo et al. (2009) nd that mandatory audit rm rotation has no impact on audit
quality in their study of Spanish rms.
7. Carey and Simnett (2006) nd no evidence of an association of long audit tenure with
abnormal accruals.
8. Francis (2011) presents a framework of the audit process that provides a better
understanding of the multiple drivers of audit quality.
9. Current behavioral research on the issue is scant, with Dopuch et al. (2001) being one notable
exception.
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Audit rm
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Corresponding author
David S. Jenkins can be contacted at: jenkinsd@udel.edu
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