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 AICPAs 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 managements 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 firmand 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 companys 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 clients 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 companys 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 clients needs and the auditors 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 companys 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 firms 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 clients 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 auditors 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 Spains 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. Marketbased 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.

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