Mandatory Auditor Rotation: a Way for Regulator to Prevent Audit Failures? Essay

MANDATORY AUDITOR ROTATION: A WAY FOR REGULATORS TO PREVENT AUDIT FAILURES? 1. Introduction Auditor rotation has long been a subject of debate as a measure to prevent audit failures, especially after the financial crisis. Two types of rotation suggested are firm rotation and audit partner rotation. Mandatory auditor rotation limits the number of consecutive years that a registered public accounting firm or audit partner can serve as the auditor of a company, and is claimed to be able to enhance audit quality and reduce market concentration.

The purpose of this paper is to identify, consider and evaluate the impacts of mandatory auditor rotation on audit quality and market competition and, accordingly, conclude whether mandatory auditor rotation is the way to prevent audit failures. 2. Mandatory auditor rotation in the world Different countries have different approaches towards mandatory auditor rotation. Some countries such as Australia, Canada, Denmark, Germany, Spain, etc. ave adopted audit partner rotation rather than audit firm rotation. Some countries such as Pakistan, Italy and Oman have adopted audit firm rotation only for clients in specific areas such as listed companies, financial institutions, banks and insurance companies and governmental companies. On the other hand, a large number of countries previously implemented but have now abolished mandatory rotation. For example, Spain abandoned audit firm rotation in 1995 (Ewelt-Knauer et al. , 2012).

In August 2011, Public Company Accounting Oversight Board (PCAOB) issued concept release on auditor independence and audit firm rotation but still struggle to see if it will adopt a mandatory audit firm rotation requirement for the U. S. public company auditors. In September 2012, the European Parliament discussed a rotation period of twenty years, however no final decision has been reached so far. 3. The impact of mandatory auditor rotation on audit quality a. Arguments for mandatory auditor rotation

APB’ Ethics Standard (ES) 1 “Integrity, objectivity and independence” identifies six broad “threats” to auditors’ independence. Amongst those, familiarity threat is believed to be generated by long tenure when an auditor is over-familiar with the client and does not sufficiently question the audited entity’s point of view. The rotation of partners is considered to be one of the most influential factors enhancing independence, which could be impaired by long-time tenure (Beattie et al. , 1999).

Elitzur and Falk (1996) show that known and finite audit engagement periods jeopardize audit quality over time and the last period has the lowest level of audit quality. This is the consequence of auditors becoming excessively familiar with their clients, hence, “not exhibiting sufficient professional skepticism” (Arel et al. , 2005). In contrast, new auditors bring a “fresh look” and different perspective to the financial statements. The case of Enron and Andersen is a magnificent example. As well as this, Arel et al. 2005) also worried that the staleness and redundancy lead to the tendency to anticipate results and base them on prior year’s findings. Moreover, eagerness to please the client exists in long-term tenure such as negotiation for potential long-term audit fees and unconscious desire to please the client. Mandatory rotation could help to remove these problems. In an experimental study, Nicholas et al. (2000) also concluded that rotation can increase auditor independence either as a stand-alone rule or in conjunction with mandatory retention. b. Arguments against mandatory auditor rotation

The key disadvantage of mandatory auditor rotation is the loss of the current auditor’s cumulative knowledge of the company’s business, processes, systems, people, and risks (PwC, 2012). These experience and knowledge is essential to a high quality audit and audit quality “tends to improve rather than worsen with tenure, providing support to the expectation that there is a significant learning process for the auditor, i. e. , an auditor needs time to get to know sufficiently well the business of the client and, consequently, audit quality tends to increase over time” (Cameron et al. 2010). Audit quality really suffers when auditor lack a sound base of experience and understanding concerning a public company’s business (AICPA, 2011). Furthermore, while maintaining professional skepticism is of significance to auditors, the close relationship built up is also critical to the audit process. Hence, auditor-client communication may suffer from mandatory auditor rotation due to time constraints (Arel et al. , 2005). In terms of audit committees, the rotation would consume a significant amount of time due to a “getting to know each other” stage (Arel et al. 2005). As a result, “the frequency of audit firm changes will distract management and audit committees from their core responsibilities during the proposal and on-boarding process, potentially reducing their focus on the effectiveness of internal controls and the quality of financial information provided to investors” (PwC, 2012). A study of Italy’s 20 year-experience of having mandatory auditor rotation in place concluded that audit quality tends to increase as audit tenure increases (stand). From a study of Spain’s experience, Emiliano et al. 2009) concluded that mandatory rotation not only fails to enhance auditor independence but may in fact harm independence because market-based mechanisms to safeguard independence, such as reputation concerns, are less effective under a mandatory rotation regime. Moreover, it is worth a mention that while the majority of research suggests either no effect or a negative effect of mandatory auditor rotation in relation to ‘independence in fact’, there is a positive effect from ‘independence in appearance’. In other words, financial statement users’ regard the auditor as more independent (Ewelt-Knauer et al. 2012). 4. The impact of mandatory auditor rotation on market competition c. Arguments for mandatory auditor rotation Plenty of regulators have expressed concerns for the concentration for the audit market and the dominance of the large firms. Also, there have been many commentators on the positive effects of mandatory rotation on reducing concentration and increase competition. In its recent provisional findings report, U. K. Competition Commission (CC) found that 31% of FTSE 100 companies and 20% of FTSE 250 companies have used the same audit firm for more than 20 years.

In addition, 67% of FTSE 100 companies and 52% of FTSE 250 companies have used the same audit firm for more than 10 years. This lack of healthy competition in the market place results in poor audit quality, which focused on management’s needs, rather than that of the shareholders (Accountancy Live, 2013). CC also proposed mandatory auditor tendering, after perhaps five or seven years with mandatory auditor rotation after, possibly two tender processes to improve market competition. d. Argument against mandatory audit rotation

While mandatory firm rotation is believed to be a good measure to deal with the issue of market concentration, it seems to be just an unsubstantial presumption of regulators. Proponents of rotation rules argue that it might lead to smaller firms being given the opportunity to compete with the large audit firms. However, smaller audit firms might also suffer from the rotation, accordingly, leading to higher market concentration. Firstly, the empirical evidences in Italy show that large audit firms might collude to refer audit clients (SDA, 2002).

Secondly, with the emergence of multinational corporations, it is hard for them to seek new audit firms who “have the capacity to handle all of the accounting demands of an enterprise that is actively engaged in dozens of locales across the globe” (FEI, 2012). In addition, small-to medium-sized firms may be perceived to lack the necessary resources and expertise to handle frequent rotations (IDW, 2012a). As a result, audit committees will tend to select large audit firms, which is in contrast with the regulators’ aim to reduce the concentration in the global market place.

In addition, mandatory auditor rotation has received significant criticism from auditor firms in terms of increasing market competition. Ernst & Young argues that mandatory does not reduce audit market concentration (Ernst & Young, 2013). PwC argues that there is already intense competition and that such artificial market interventions as mandatory firm rotation will “lead to significant adverse consequences – lower quality, less innovation and reduced efficiency resulting in higher prices” (PwC, 2012). 5.

Conclusion The report highlights how mandatory auditor rotation affects the quality of auditors’ work and audit market competition. An overview of different countries’ experiences with mandatory auditor rotation was given. Then the report examined, in detail, both the expected and observed advantages and disadvantages of audit quality according to mandatory auditor rotation once implemented. It is obvious that while there is some research indicating the benefits of rotation, these benefits are far from certain.

In contrast, more evidence points out that mandatory auditor rotation costs overweight its perceived benefits. Specifically, the loss of institutional knowledge and auditor-client communication could lead to potential market failures. More surprisingly, long tenure might increase audit quality. The report then discussed the idea of enhancing competition in the audit market through mandatory audit rotation. The idea is widely supported by several regulators however there are stills barriers for smaller audit companies to be competent enough to join the race.

Given the potential, detrimental impacts of mandatory auditor rotation on audit quality and market competition, mandatory auditor rotation might offer an imperfection solution to audit failures. It is advisory alternative measures should be considered. BIBLIOGRAPHY Ewelt-Knauer, C. , Gold, A. , Pott, C. , 2012. How do we know about mandatory audit firm rotation?. [Online] Available at: http://icas. org. uk/mafr/ [Accessed 10 April 2013]. Auditing Practice Board (APB), 2008b. APB Ethical Standards Glossary of Terms. London: Financial Reporting Council. Elitzur, R. Falk, H. F. , 1996. Planned Audit Quality. Journal of Accounting and Public Policy. 15. pp 247-269. Arel, B. , Brody, R. G. , Pany, K, 2005. Audit firm rotation and audit quality. The CPA Journal. January. Nicholas Dopuch, Ronald R. King and Rachel Schwartz, 2001. An experimental Investigation of Retention and Rotation Requirements. Journal of Accounting Research Vol. 39. No. 1 (Jun. , 2001). pp. 93-117. [Online] Available at: http://www. jstor. org/discover/10. 2307/2672947? uid=3738032&uid=2&uid=4&sid=21102221836217 [Accessed 10 April 2013] PwC, 2012.

Mandatory audit firm rotation: Why other changes would be better for investors. [Online] Available at: http://www. pwc. com/us/en/point-of-view/mandatory-audit-firm-rotation. jhtml [Accessed 10 April 2013]. Bocconi University (Milan- Italy) and IE Business School (Madrid- Spain), Cameran, M. , Prencipe, A. , Trombetta, M. , 2010, Auditor Tenure and Auditor Change: Does Mandatory Auditor Rotation Really Improve Audit Quality?. [Online] Available at: http://www. uc3m. es/portal/page/portal/inst_desarr_empres_carmen_vidal_ballester/investigacion/seminarios/seminarios_2010/Does%20mandatory%20auditor%20rotat on%20really%20improve%20audit%20qua. pdf [Accessed 10 April 2013] AICPA, 2011, Re: Request for Public Comment: Concept Release on Auditor Independence and Audit Firm Rotation. [Online] Available at: http://pcaobus. org/Rules/Rulemaking/Docket037/413_AICPA. pdf [Accessed 10 April 2013] Ernst & Young, 2013. Q&A on mandatory firm rotation. [Online] Available at: 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 [Accessed 10 April 2013]

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