Audit firm 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 firm rotation both in the USA and in other countries. Design/methodology/approach – The authors outline the unresolved nature of academic research on audit firm 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 finding 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 firm 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 firm 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 five-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 firm 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 firm rotation. On one side, investors are generally in favor of a rotation requirement as a “powerful antidote” to auditor conflicts of interests which they believe will significantly 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 significant 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 firm 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 q Emerald Group Publishing Limited 1030-9616 DOI 10.1108/ARJ-11-2012-0087 Audit firm rotation 75 for years to come. In addition, the PCAOB’s discussions may trigger states governments within the USA to consider audit firm rotation for nonprofits and public companies may consider voluntary audit firm rotation as a positive signal to the financial markets[2]. Given the importance of this issue, this article: . discusses the regulatory background of audit firm rotation in the USA and other countries; . provides an overview of academic research that has examined audit firm 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 firms, with their clients, and the larger business and investor communities. Regulatory background of audit firm rotation in the USA and other countries USA For more than 35 years, US regulators have considered a regulatory limitation on audit firm 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 firm and a client may lead to such a close identification of each interest that truly independent action by the audit firm becomes difficult. The report further noted that: [ ] one alternative is a mandatory change of accountants after a given period of time, or after any finding by the SEC that the accounting firm failed to exercise independent action to protect investors and the public (Metcalf Report, 1977). In the following year, the American Institute of Certified Public Accountants’ Commission on Auditor’s Responsibility, better known as the Cohen Commission, reached a different conclusion regarding audit firm rotation. The commission recommended against mandatory audit firm rotation because the: [ ] cost of mandatory rotation would be high and the benefits that financial statement users might gain would be offset by the loss of benefits 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 firm rotation in the USA was fairly dormant until late 2001. In fact, the Treadway Commission, a private-sector initiative of the American Institute of Certified 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 firm rotation; rather it recommended that audit firms 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 76 and provide any recommendations for legislation. In this staff report, the SEC indicated that the profession’s requirement for a periodic change in the engagement partner in charge, especially coupled with the requirement for second partner reviews, provides a sufficient opportunity for bringing a fresh viewpoint to the audit without creating the significant costs and risks associated with changing accounting firms that were identified by the Cohen Commission (SEC, 1994). In late 2001, with the failure of Enron, WorldCom, and Global Crossing, the issue of mandatory audit firm 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 Office (GAO) to study the potential effects of mandatory audit firm 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 firm rotation, given that sufficient 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 firms for eight years. Australia Besides the USA, other countries are considering mandatory audit firm 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 financial statements for the 18 months ended June 30, 2012. Given this deterioration, Mr Medcraft noted that he will recommend mandatory audit firm 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 EU’s three billion bailout of banks during the credit crises, Michael Barnier, Internal Markets Commissioner of the European Commission, suggested that “mandatory audit firm 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 firm rotation has deprived audit of its ethos: professional skepticism” (Orlik, 2011, p. 1). Academic research examining audit firm rotation in the USA Since audit firm rotation is generally not required in the USA, academic research examining audit firm 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 firm rotation, Carey and Simnett (2006) suggest that auditor tenure studies do examine the fundamental underlying objective of mandatory audit Audit firm rotation 77 firm rotation, i.e. that after a long period of tenure, continuing relationships between a client and audit firm may impact a firm’s independence, and time may deteriorate a firm’s ability for critical appraisal. Thus, researchers suggest that the results from auditor tenure studies can shed light on the efficacy of a policy of mandatory audit firm 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 financial 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 firm tenure from an investor perspective. Specifically, these studies have examined whether a relationship exists between audit firm tenure and the cost of borrowing (Mansi et al., 2004), earnings response coefficients (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-specific equity risk premiums and document a nonlinear relation. Specifically, they find 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) find 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 firms. In a similar vein, Jenkins and Velury (2008) examine the relation between auditor tenure and reporting conservatism and report similar findings. In general, these “nonlinear” studies indicate that audit quality generally goes through two distinct phases during the auditor-client relationship. During the early years referred to as the “auditor learning” phase, auditors become more familiar with the client and audit 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 findings get us no closer to resolving the mandatory rotation issue as the results indicate that there may be merit to both sides of the argument. Academic research examining audit firm rotation outside the USA Although academic studies in the USA have been primarily limited to voluntary auditor tenure studies, academic researchers have examined audit firm 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 firm tenure on audit quality in Korea where mandatory audit firm rotation is required for problematic firms[5]. The authors find that firms with mandatory auditor changes report significantly lower discretionary accruals compared ARJ 26,1 78 Publication Auditor tenure variable Audit quality measure Academic operationalization of audit quality measure Myers et al. (2003) Stanley and DeZoort (2009) Audit firm tenure (number of consecutive years the firm has retained auditor) Accounting restatements Correction of a previously issued financial statement, usually because of an accounting irregularity or misrepresentation caused by an error or fraud Geiger and Raghunandan (2002) Natural log of audit firm tenure Auditor reporting failures Client bankruptcy with no prior going concern modified audit opinion Johnson et al. (2002) Gul et al. (2007) Audit firm tenure Natural log of audit firm tenure Discretionary accruals Total accounting accruals less nondiscretionary accruals (business conditions, such as growth and length of operating cycle, that naturally create and destroy accruals). Nondiscretionary accruals are estimated using a regression model Carcello and Nagy (2004) Dichotomous variables for short (three years or less) and long (nine years or more) audit firm tenure Material misstatement Company and/or its officers charged by the SEC with a violation of Rule 10(b) – of the 1934 Securities Exchange Act in an Accounting and Auditing Enforcement Release Carey and Simnett (2006) Audit partner tenure using dichotomous variables for short (two years or less) and long (more than seven years) partner tenure Going-concern opinions Abnormal working capital accruals (AWCA) Meeting/missing earnings benchmarks Likelihood of issuing going-concern opinion for distressed companies Difference between realized and expected working capital (based on working capital to sales ratio) Small loss and small earnings decrease avoidance Table I. Audit quality measures as operationalized in audit firm tenure studies Audit firm rotation 79 to firms with voluntary auditor changes, suggesting that mandatory audit firm rotation improves audit quality. In contrast, Firth et al. (2012) examine the impact of both mandatory and voluntary audit firm rotation under different regulatory environments in China. Using an auditor’s propensity to issue a modified audit opinion as a proxy for audit quality, Firth et al. (2012) find that mandatory audit firm rotation has a limited impact on audit quality, with the effect restricted to firms located in less developed regions.[6] Although Australia currently does not have mandatory audit firm 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 find a lower propensity to issue a going concern modified 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 find that the introduction of mandatory rules after 2005 significantly reduced the incidence of long partner tenure; with auditors in locations outside Australia’s 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 firms and to firms 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 find 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 firms fairly equally. Overall, similar to studies of firms in the USA, collective evidence from international studies on audit firm 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 firm tenure (number of consecutive years the firm 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 firm tenure (number of consecutive years the firm has retained auditor) Earnings response coefficient (ERC) Estimate of the change in a company’s stock price from the information provided in its earnings announcement Boone et al. (2008) Audit firm 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 firm tenure studies ARJ 26,1 80 Future direction Given the unresolved nature of academic research on audit firm rotation 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 necessary to this point because of data limitations, doing so introduces measurement error to the models as a variety of factors, outside of audit quality, can affect earnings characteristics and investor perceptions. Second, while the literature has identified 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 finer 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 benefits/detriments of audit firm rotation 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 how auditor tenure manifests in auditor characteristics such as auditor learning and auditor closeness could provide better model specifications than simply counting the number of consecutive years an auditor has audited a client. Finally, practitioner input regarding the identification and measurement of costs associated with auditor rotation could help balance current research that is focused on benefits/detriments of rotation on audit quality. Summary and conclu sion Overall, we feel that existing research and related policy decisions on audit firm 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 firm 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 nonprofits. 3. See Table I for a description of the various definitions of audit quality as operationalized in audit firm tenure studies. Audit firm rotation 81 4. See Table II for a description of the various definitions of investor perception of audit quality as operationalized in audit firm tenure studies. 5. The Korean Financial Supervisory Commission, equivalent to the SEC in the USA, defines a problematic firm as one with high agency problems (e.g. insufficient separation of ownership and management), financial 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) find that mandatory audit firm rotation has no impact on audit quality in their study of Spanish firms. 7. Carey and Simnett (2006) find 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. References AICPA (2011), Request for Public Comment: Concept Release on Auditor Independence and Audit Firm Rotation, American Institute of CPAs, Durham, NC, available at: http://media. journalofaccountancy.com/JOA/Issues/2011/12/AICPA_Letter_PCAOB_Concept_Release_ MFR.pdf Boone, J., Khurana, I. and Raman, K. (2008), “Audit firm tenure and the equity risk premium”, Journal of Accounting, Auditing, and Finance, Vol. 23 No. 1, pp. 115-140. Carcello, J. and Nagy, A. (2004), “Audit firm tenure and fraudulent financial reporting”, Auditing: A Journal of Practice & Theory, Vol. 23 No. 2, pp. 55-69. Carey, P. and Simnett, R. (2006), “Audit partner tenure and audit quality”, The Accounting Review, Vol. 81 No. 3, pp. 653-676. Chapple, E. and Hossain, S. (2011), “Mandatory auditor rotation: Australian evidence”, Australian Journal of Corporate Law, Vol. 25, pp. 303-317. Cohen Commission (1977), The Commission on Auditors’ Responsibilities: Report, Conclusions, and Recommendations, American Institute of Certified Public Accountants, New York, NY. Davis, R., Soo, B. and Trompeter, G. (2009), “Auditor tenure and the ability to meet or beat earnings forecasts”, Contemporary Accounting Research, Vol. 26 No. 2, pp. 517-548. Dopuch, N., King, R. and Schwartz, R. (2001), “An experimental investigation of retention and rotation requirements”, Journal of Accounting Research, Vol. 39 No. 1, pp. 93-117. Durkin, P. (2012), “ASIC threatens auditors with mandatory rotation”, The Australian Financial Review, December 5. Firth, M., Rui, O. and Wu, X. (2012), “How do various forms of auditor rotation affect audit quality? Evidence from China”, The International Journal of Accounting, Vol. 47 No. 1, pp. 109-138. Francis, J. (2011), “A framework for understanding and researching audit quality”, Auditing: A Journal of Practice & Theory, Vol. 30 No. 2, pp. 125-152. Geiger, M. and Raghunandan, K. (2002), “Auditor tenure and audit reporting failures”, Auditing: A Journal of Practice & Theory, Vol. 21 No. 1, pp. 67-78. Ghosh, A. and Moon, D. (2005), “Auditor tenure and perceptions of audit quality”, The Accounting Review, Vol. 80 No. 2, pp. 585-612. ARJ 26,1 82 Gul, F., Fung, S. and Krishnan, G. (2007), “Auditor independence: evidence on the joint effects of auditor tenure and nonaudit fees”, Auditing: A Journal of Practice & Theory, Vol. 26 No. 2, pp. 117-142. IIA (2012), “Mandatory audit firm rotation too costly with minimal benefit”, Institute of Internal Auditors, available at: http://inaudit.com/regulatory/mandatory-audit-firm-rotation-too- costly-with-minimal-benefit-iia-12870/ Jenkins, D. and Velury, U. (2008), “Does auditor tenure influence the reporting of conservative earnings?”, Journal of Accounting & Public Policy, Vol. 27 No. 2, pp. 115-132. JOA (2011), “PCAOB will weigh audit term limits”, Journal of Accountancy, June, available at: www.journalofaccountancy.com/Web/20114222.htm Johnson, V., Khurana, I. and Reynolds, J. (2002), “Audit-firm tenure and the quality of financial reports”, Contemporary Accounting Research, Vol. 19 No. 4, pp. 637-660. Kim, J. and Yi, C. (2009), “Does auditor designation by the regulatory authority improve audit quality? Evidence from Korea”, Journal of Accounting & Public Policy, Vol. 28 No. 3, pp. 207-230. Mansi, S., Maxwell, W. and Miller, D. (2004), “Does auditor quality and tenure matter to investors? Evidence from bond market”, Journal of Accounting Research, Vol. 42 No. 4, pp. 755-793. Metcalf Report (1977), “The accounting establishment iii”, Staff of Subcommittee on Reports, Accounting, and Management of the Senate Committee on Government Operations, 95th US Congress. Myers, J., Myers, L. and Omer, T. (2003), “Exploring the term of the auditor-client relationship and the quality of earnings: a case for mandatory auditor rotation”, The Accounting Review, Vol. 78 No. 3, pp. 779-799. Orlik, R. (2011), “EU to propose audit-only firms and mandatory rotation”, Accountancy Age, September 26. PCAOB (2011), “Concept release on auditor independence and audit firm rotation”, PCAOB Release No. 2011-006, Public Company Accounting Oversight Board, August 16. Ruiz-Barbadillo, E., Go ´ mez-Aguilar, N. and Carrera, N. (2009), “Does mandatory audit form rotation enhance auditor independence? Evidence from Spain”, Auditing: A Journal of Practice & Theory, Vol. 28 No. 1, pp. 113-135. Ryken, K., Radich, R. and Fargher, N. (2007), “Audit partner rotation: evidence of changes in audit partner tenure as the result of mandatory regulation in Australia”, Current Issues in Auditing, Vol. 1, pp. A28-A35. SEC (1994), Staff Report on Auditor Independence, Securities and Exchange Commission, Washington, DC. Stanley, J. and DeZoort, T. (2009), “Audit firm tenure and financial restatements: an analysis of industry specialization and fee effects”, Journal of Accounting & Public Policy, Vol. 26 No. 2, pp. 131-159. Wyatt, E. (2011), “Accounting board to seek comments on rotating auditors”, New York Times, August 16. Further reading Blouin, J., Grien, B. and Roundtree, B. (2007), “An analysis of forced auditor change: the case of former Arthur Andersen clients”, The Accounting Review, Vol. 82 No. 3, pp. 621-650. Audit firm rotation 83 Cahan, S. and Zhang, W. (2006), “After Enron: auditor conservatism and ex-Andersen clients”, The Accounting Review, Vol. 81 No. 1, pp. 49-82. Krishnan, J., Raghunandan, K. and Yang, J. (2007), “Were former Andersen clients treated more leniently than other clients? Evidence from going-concern modified opinions”, Accounting Horizons, Vol. 21 No. 4, pp. 423-435. Nagy, A. (2005), “Mandatory audit firm turnover, financial reporting quality, and client bargaining power: the case of Arthur Andersen”, Accounting Horizons, Vol. 19, pp. 51-68. Corresponding author David S. Jenkins can be contacted at: jenkinsd@udel.edu ARJ 26,1 84 To purchase reprints of this article please e-mail: reprints@emeraldinsight.com Or visit our web site for further details: www.emeraldinsight.com/reprints . 11 7-1 42. IIA (2012), “Mandatory audit firm rotation too costly with minimal benefit”, Institute of Internal Auditors, available at: http://inaudit.com/regulatory/mandatory -audit- firm -rotation- too- costly-with-minimal-benefit-iia-12870/ Jenkins, . for understanding and researching audit quality , Auditing: A Journal of Practice & Theory, Vol. 30 No. 2, pp. 12 5-1 52. Geiger, M. and Raghunandan, K. (2002), “Auditor tenure and audit reporting. Audit firm rotation and audit quality: evidence from academic research David S. Jenkins and Thomas E. Vermeer Department of Accounting & MIS, University