Does the Rotation of Auditors Improve the Quality of Auditing - Essay Example

? Does the rotation of auditors improve the quality of auditing? Introduction Mandatory audit firm rotation (MAR) has been a topic for debate for many years among practitioners and academic experts.1 With the current economic crisis and audit reporting failures, such as, Parmalat and Enron, this issue has gained further significance, and has resulted in many governments imposing various modifications in accountability, on both auditors and financial reports, aimed at curtailing chances of fraud. In this context, the Sarbanes-Oxley act was implemented in the US that aimed at bringing back public faith in financial reports. The Sarbanes-Oxley Act made it mandatory for the auditor to be replaced after every five years in the US. The European Commission, however, did not mandate a compulsory auditor rotation, and recommended in its proposal implementation of audit firm rotation and change of audit firms every six to nine years (European Commission, 2010).2 Globally, mixed approaches have been adopted as regard MAR, and in many countries such as the UK, audit partner rotation is given preference over firm rotation, while the regulators in Germany, the US and the UK have derived that potential advantages of MAR fail to outweigh costs incurred and other associated risks. 3 In this context, the essay will review the available literature that analyses whether rotation of auditors improve quality of auditing. It will use deductive reasoning to derive that while there are not much empirical data that prove MAR significantly improves audit quality, at the same time, there is not much conclusive evidence that shows MAR has an adverse effect on audit quality, thus keeping the debate open. Discussion Audit, audit quality and auditor rotation In the UK, it is mandatory for all public sector organisations and large business firms to produce an annual, audited financial report. In this context, the term auditing refers to “a systematic process of objectively gathering and evaluating evidence relating to assertions about economic actions and events in which the individual or organisation making the assertions has been engaged, to ascertain the degrees of correspondence between these assertions and established criteria.”4 The Public Company Accounting Oversight Board (PCAOB) had recently published a report asking for public suggestions on the improvement of audit quality and auditor independence, wherein auditor rotation was taken into consideration.5 There are varying opinions on the effects of auditor rotation, and researches have revealed that existing literature fails to derive conclusively on the effects of audit rotation, hence researchers must be careful when analysing audit rotation reports from the past.6 Supporters for auditor rotation claimed that a long-term relationship between an auditor and a company develops a feeling of dependency that in turn diminishes audit quality.7 However, those against auditor rotation claimed that auditor rotation is an expensive process and the costs far exceed any derived advantages.8 Furthermore, they also claimed that auditor rotation is a hurdle, in regard developing a relationship between the firm’s managers and auditors based on confidence and trust, and social exposures between the two often lead to improved audit quality, without hampering auditor independence.9 The theoretical debate on the issue of auditor rotation is based on how one views the auditor. If the auditor is seen as a medium for wealth optimisation, there are various theories that support the concept that there is an improvement of audit quality due to rotation.10 However, if one viewed the auditor as an agent for the principals, rotation is deemed disadvantageous, and a long-term relationship would allow the auditor to get a better understanding of the principals’ objectives, thus making him/her a better auditor.11 The term ‘audit quality’ denotes the probability that an auditor will find shortcomings within a firm’s accounting system (competence), and will report on them (independence).12 However, making it functional and correctly measuring audit quality is a problematic issue, acknowledged by both the supporters and opponents of auditor rotation. Researchers have contended that audit quality is an intangible concept, hence almost impossible to measure, and to find out the changes or variations in audit quality, often proxy variables must be used (Wooten, 2003).13 Auditor rotation is a process wherein a “mandatory…rotation sets a limit on the number of years a public accounting firm may audit a company’s financial statements. After a predetermined period, an accounting firm is no longer eligible to serve as the company’s auditor for a set time interval and a rotation of firms is required. In some jurisdictions, the requirement may be applied only to a particular sector, such as financial institutions, or only to public interest entities in the jurisdiction.”14 Audit rotation has received attention in the recent years from policy-makers, since the process is viewed as a potential method to improve audit quality and auditor independence. Rotation aims at improving audit quality by preventing the establishment of close and long-term relationships between a company and an auditor, while restricting the financial reliance of auditors on the firms they audit.15 It is also assumed that rotation would help in decreasing audit market concentration, by creating more business opportunities, especially for the smaller companies.16 Advantages of auditor rotation Proponents of auditor rotation contend that mandatory rotation or MAR, affects the competence and independence of the auditors, the two main components of audit quality. MAR lessens the interactions between an auditor and the client, thus disallowing the establishment of a relationship, which in turn improves objectivity and independence. A long-term relationship between the auditor and a client may produce negative effects on professional independence, hence lowering audit quality. This is owing to the fact that the auditor builds up a close relationship with the client by interacting closely with him/her, strengthening the bond between them. As a result, there are chances that the auditor may overlook breaches in the client’s accounting system, and fail to report them, thus alleviating audit quality. An auditor when personally involved may start identifying himself/herself with the interests of the client firm, instead of keeping in mind stakeholders’ interests. On the contrary, a new auditor would provide a fresh view to the client’s accounting system, which would allow him/her to be more objective.17 In fact, MAR was started in the US primarily for bringing in a new perspective periodically during audits.18 Another positive effect of MAR is the creation of an ‘independent appearance’ of the auditors, wherein, investors will view auditors as possessing more independence after a rotation, which will be advantageous in terms of creating a perception of the company’s financial statement, benefitting the company and market reactions, both.19 Another theory in favour of MAR contended that the process might benefit smaller audit firms by providing them an opportunity to take part in the market owing to increased competition. This is observed in Italy, where rotations are used in bargaining for lower audit rates per hour, creating a potential for increasing competition within the audit market.20 Disadvantages of auditor rotation The opponents of MAR claim that while there are no conclusive beneficial effects of MAR on audit quality, researches showed that rotation might have an adverse effect, especially in the context where the rotation period is short.21 On the other hand, when the tenure is long, it helps the auditor to gain a better understanding and knowledge about the client company, while at the same time creating an awareness of associated risks, which can work towards elevating audit quality. Besides this, owing to MAR, there is a lack of in-depth knowledge about the client, which may eventually lead to an audit failure. Longer audit tenure also allows the audit firm to develop credibility, expertise and experience, thus helping in improving audit quality.22 However, despite these findings, the researches cannot conclusively prove that auditor rotation does not help in improving the audit quality. In another argument, researchers claimed that MAR does not provide for an improved audit quality. Instead, as observed in the learning graph, any new audit might turn out be less efficient at start, wherein it may result in increased costs (for both the audit firm and client) incurred during speeding up the learning process.23 Furthermore, costs associated with MAR may also increase under certain circumstances, as for example, during business mergers changing an auditor could be both expensive and complicated. In this context, however, Ewelt-Knauer, Gold and Pott contended that, “[in] Rotation…the cost of capital should decrease in the long run. Furthermore, archival research generally suggests that audit firm tenure increases the cost of companies’ capital…mandatory rotation interrupts tenure and hence might prevent those increases to costs of capital due to tenure…[while] investors might be willing to bear some added costs if the result is a better audit.” 24 Researches from the Italian and Korean audit markets, however, show that MAR does not increase market competition; instead, there are chances that it may create a higher market concentration, thus adding to the potential disadvantages. Alternatives to the MAR Owing to a lack of conclusive evidence that proves beyond doubt the link between MAR and improved audit quality, regulators must necessarily take into consideration other alternatives. An alternative to MAR is the rotation of the audit partners, which significantly alleviates the risk of self-interest and familiarity, and allows for increased objectivity without incurring additional costs (IESBA, 2013).25 Audit committees with clear objectives and qualified members are also an alternative to MAR, wherein the committee reinforces auditor independence. Besides this, external auditor oversight regulations can help to improve audit quality, while the use of international global standards, such as the IESBA code of Ethics, would help to remove all uncertainties and gain investor trust. Conclusion From the above review, it can be deduced that the various researches that analyse effects of MAR on audit quality, suggested that there are implications that rotation tend to improve audit quality and auditor independence; however, one cannot entirely ignore the suggested negative effects that MAR might have on an auditor’s client- specific competence and knowledge. Owing to the current lack of evidence that conclusively relates MAR with improved audit quality, policy-makers and regulators must necessarily be careful in correctly ascertaining the long-term goals of MAR, before implementing the procedure. References American Institute of Certified Public Accountants or AICPA. Statement of position regarding mandatory rotation of audit firms of publicly held companies. NY: AICPA, 1992. Antle Rick. “The Auditor as an Economic Agent.” Journal of Accounting Research 20 (2), (Autumn 1982), 503-527. APB (2009). “Long Association with the Audit Engagement.” APB Ethical Standard 3 (Revised), (online), http://www.frc.org.uk/Our-Work/Publications/APB/ES-3-(Revised)-Long-Association-with-the-Audit-Eng.aspx Arel Barbara, Brody Richard and Pany Kurt. “Audit Firm Rotation and Audit Quality.” The CPA Journal 75 (1), (2005), 36-39. Bedard Jean and Johnstone, Karla “Audit partner tenure and audit planning and pricing.” Auditing: A Journal of Practice & Theory 29(2), (2010), 45-70. Cameran Mara, Prencipe Annalisa and Trombetta Marco (2012), Mandatory Audit Firm Rotation and Audit Quality: Evidence from the Italian Setting, (online) http://www.uam.es/otros/catedraccc/docs/prencipe.pdf Casterella, Jeffrey and Johnston Derek. “Can the academic literature contribute to the debate over mandatory audit firm rotation?” Elsevier 25(1), (2013), 108-116. Davis James, Schoorman, David, and Donaldson, Lex. “Toward a stewardship theory of management.” Academy of Management Review 22 (1), (1997), 20-47. Deis Donald, and Giroux, Gary. “The Effect of Auditor Changes on Audit Fees, Audit Hours, and Audit Quality.” Journal of Accounting and Public Policy 15, (1996), 55-76. Ernst & Young. (2013). Point of view- Q&A on mandatory firm rotation. (online), http://www.ey.com/Publication/vwLUAssets/Point_of_view_-_QandA_on_mandatory_firm_rotation/$FILE/Point_of_view_Our_perspective_on_issues_of_concern_Q_and_A.pdf European Commission. (2010). Audit Policy: Lessons from the Crisis. (online) http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=COM:2010:0561:FIN:EN:PDF Ewelt-Knauer, Corinna, Gold, Anna, and Pott, Christiane. (2012) What do we know about mandatory audit firm rotation? ICAS, (online), http://icas.org.uk/mafr/ Fitzgerald Brian, Thompson Anne, and Omer Thomas. Audit partner and audit firm rotation and the assessment of internal control deficiencies. Working paper (2012). Ghosh Aloke and Moon Doocheol. “Auditor tenure and perceptions of audit quality.” The Accounting Review 80, (2005), 585–612. Healey Thomas and Kim Yi-Jin. “The benefits of mandatory audit rotation.” Regulation 26(3), (2003), 10–12. IESBA. (2013). Handbook of the Code of Ethics for Professional Accountants. (online), http://www.ifac.org/sites/default/files/publications/files/2013-IESBA-Handbook.pdf International Chamber of commerce or ICC. The adverse effects of compulsory audit firm rotation. Final statement, 4th March 2005. Institute of Chartered Accountants in England and Wales or ICAEW. Mandatory rotation of audit firms. London: ICAEW, 2002. Kwon Soo Young, Lim Young, and Simnett, Roger. Mandatory audit firm rotation and audit quality: Evidence from the Korean audit market. Working paper, 2010. Locatelli Mary. “God internal controls and auditor independence.” The CPA Journal 72 (10), (Oct 2002), 12-15. Porter Brenda, Simon Jon, and Hatherly David. Principles of External Auditing (3rd ed). West Sussex: Wiley and sons, 2009. Public Company Accounting Oversight Board or PCAOB. (2011). Concept Release on Auditor Independence and Audit Firm Rotation. (online), http://pcaobus.org/rules/rulemaking/docket037/release_2011-006.pdf Wooten Thomas. “Research about audit quality.” The CPA Journal 73 (1), (2003), 48- 50. Read More