Mandatory Audit Firm Rotation and Audit Quality

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The Chancellor of the Exchequer and the Secretary of State for Trade and Industry developed the Co-ordinating Group on Audit and Accounting Issues (CGAA) to guarantee an organized and all-inclusive procedure whereby separate regulators would be able to review the United Kingdom’s regulatory provisions for statutory audits and financial reporting statements. The CGAA is charged with requesting that accounting work be reviewed and overlap be avoided in assignments. By monitoring accounting work and eliminating overlap, the CGAA is able to review the competence of and acceptability of financials. In addition, the CGAA makes recommendations for corrections and additional research.

In January 2003 the CGAA recommended that the United Kingdom shore up the auditing process by utilizing mandatory audit firm rotation. These requirements restrict the number of years that a single audit partner or firm can audit the same company’s books. Previously the maximum number of years a company could use the same auditing firm was seven; in 2003 this was reduced to five years. The United Kingdom implemented audit rules whereby the total maximum limit on the number of years a primary auditor could remain in a position whereby it was seven years. The rationale behind the United Kingdom’s decision to increase the number of mandatory audit firm rotations thereby decreasing the tenure of auditors in relationships with a particular company was that the constraints of the audit rotation improved auditor’s independence.

In the United Kingdom, the main complaints about audit rotation come from companies that alleged the rule would reduce audit quality because it would take time for new auditors to acquaint themselves with a given company’s books. Another complaint from United Kingdom companies was that the cost increase of audit rotation does not offset the possible benefits. These companies contend that there is no evidence to support the idea that rotating auditors increases audit quality. They also suggest that a new auditor might breach the independence rule accidentally.

In the United States, 2003 saw so much pressure from companies that did not want to hire a rotation of auditors that the Security and Exchange Commission (SEC) studied mandatory rotation and determined that they could perceive no benefit to the rotation rule. They equivocated though, stating that they also did not know if mandatory rotation might be more effective in the future. Currently, the SEC has set no regulatory limits on the length of time that an accounting firm can audit the same company. The most resistance comes from Fortune 1000 companies and their auditors who object to mandatory audit rotation but offer no alternative policy. Expect that these United States companies will continue to resist regulation and will not implement self-regulation. They will simply allow for limitless tenure and place any burden of auditor independence on public accounting firms.

One of the main objections to lack of regulation is that when a single auditing firm is repeatedly compensated for auditing a given company that auditing firms will work to preserve the business relationship. The fact that the accounting firms will want to retain these companies as clients because they increase the firm’s revenues is one of the main factors that lead proponents to support mandatory rotation. Allowing new auditors to review a company’s financials will allow for a “fresh look” and that will actually assist the company in presenting accurate information to their investors. New auditors will be better able to handle challenging issues in the audit because they will not be working on the assumption that they must please the company executives in order to maintain a long-term relationship. The auditor’s tenure is already limited in the case of mandatory rotation so there is no financial reason to succumb to pressure from the company or their in-house auditors.

Opponents of rotation claim that changing auditors increase the risk of an audit failure during the initial years as the new auditor acquires the knowledge of the public company’s operations, systems, and financial reporting practices. In 2008 the United States General Accounting Office (GOA) studied the rule and made the same observations as were made in 2003, to wit, mandatory rotation may or may not make any difference. In recent news, the United States House of Representatives barred the Public Company Accounting Oversight Board from demanding mandatory rotation for public companies in the United States.

In the United States, the mandatory rotation has been around since the early 1960s and the rule has been debated since its origin. Companies have opposed mandatory rotation from the beginning, and the majority of literature indicates that “auditor independence, audit quality, and increased audit costs” are foremost among the reasons for opposition. Rather than view auditor independence as desirable they contend that the auditor will be unfamiliar with the company and its financial mechanisms. This condition will cause the company to, in essence, pay the new auditor for on the job training. The new auditor will then spend so much time familiarizing himself with the books that he or she will fail to identify accounting errors. This failure will be compounded yearly and the company will be left with non-compliant financial statements.

Debates about the effectiveness of mandatory rotation reached a fever pitch during auditing failures such as the one involving Enron. The goal of mandatory rotation was for the avoidance of fraud and increase audit responsibility. Placing limits on the number of years the same auditor or auditing firm could perform audits on the same company was intended to increase auditor autonomy. The hoped-for result was that there would be more accurate accounting to investors in regards to a company’s financial standing.

A major issue that mandatory rotation addressed was auditor independence. When there is a lack of auditor independence the assumption is that audit suffers. Additionally, a false picture of the company’s finances may be presented to investors. Mandatory rotation is a way to protect auditors from being pressured to preserve the accounting relationship with a given company by cooperating with the company and its in-house auditors. Another concern is that the auditor will develop a relationship with the company and its managers over time that will be detrimental to the audit quality. Audit rotation is designed to promote the confidence of stakeholders and investors who rely on quality audits and the resulting financial statements to assess the strengths and weaknesses of a given company.

Michael Power argues that the United Kingdom has experienced a rise in the demand for quality audits and accountability. Many United Kingdom companies do not support opening their books to new auditors in spite of the political and public demand for transparency in organisational activities. Powers contends that audit extensions alone cause organisational financials and operations to become ambiguous. Audits seem to be conducted in secret and the public has little or no knowledge about a given company’s financials let alone the company’s commitment to transparency. In effect, the public has ceased to trust companies and their private long-term relationships with their auditing firms.

The United Kingdom was involved in a huge scandal more than twenty years ago with the Bank of Credit and Commerce International (BCCI). The BCCI had more than 22 branches in the United Kingdom and had the main office located down the street from the Bank of England. When the dust settled on this audit failure it revealed that many in the government and in the banking industry had known the BCCI was operating fraudulently. In the end, liquidators sued the Bank of England and charged them with malicious recklessness. BCCI creditors were held liable for £74m in expenses and £57m in legal bills. The Serious Fraud Office convicted at least one person and he served jail time but has not yet made restitution. This scandal was enough to convince the United Kingdom to maintain stricter controls over its companies. News about the BCCI's closure in 1991 caused a rush on United Kingdom banks as people tried to withdraw funds from other banks in the United Kingdom. By 1994 one quarter of United Kingdom banks in this sector had failed because of the fear of closures and fraud.

Not surprisingly the pressure and opposition to mandatory rotation are strongest among Fortune 1000 companies that maintain auditor independence is not enough of a benefit to offset the companies’ increased expenses and the time it takes a new accounting firm to familiarize itself with financial statements. Top Fortune 1000 companies complain that there are only a few accounting firms operating at a high enough level that they are qualified to audit complicated books. Therefore top firms would be under pressure to retrain and rotate auditors.

Interestingly, the large media campaigns against mandatory rotation prompted an actual survey in which 62 percent of Fortune 1000 companies stated that mandatory rotation would have no effect on how investors viewed their company financials. Thereby indicating that in the company viewpoint auditor independence was not a great concern to investors. This is problematic because the survey did not ask investors directly, but rather asked company executives to speak on behalf of their investors.

The United Kingdom and the United States have referred to Italy’s mandatory audit rotation policies because they have been in effect for over 20 years. However, even the Italians continue to debate rotation. Professor Mara Cameran has written extensively on the history of auditing and on mandatory rotation. She and her colleagues tested the effectiveness of the mandatory rotation rule on audit quality in cases where mandatory rotation has been in effect for 20 years in Italy. Their conclusion was that mandatory rotation does not result improve the quality of audits. Additionally, their study claims that audit quality remains the same and in some cases, actuality improves when there is a close on-going relationship between auditor and client.

In October 2013 the United Kingdom was out-voted at European Union voted in favor of mandatory, thus out-voting the United Kingdom on this point. Recent United Kingdom officials had lobbied against rotation and offered instead a plan whereby every 10 years companies and firms would decide on whether or not they needed to rotate their auditors. European Union members disagreed with United Kingdom officials and continue to support proposals that limit the term for auditors of banks and companies.

The relationship between auditor and company demands that the auditor be independent. Being in a close on-going relationship with a client over a long period will naturally affect the auditor’s decision-making. Reading the same financials year after year with the same players can cause an auditor to be less scrupulous in their scrutiny of documents. An auditor’s conclusions and pronouncements about the soundness of a company’s financials lack objectivity if he or she is close to the company. The United Kingdom suffered greatly and still suffers from audit failures. The United States continues to bow to the pressure of business and seems unfazed by its endless stream of audit failures and financial scandals. In the United Kingdom, ethical considerations and investment in a public trust require that the government continue to support auditor independence.

Reference List

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Cameran, M., Jere R., Francis, J.R., Marra, A., and Pettinicchio, A.K., "Are There Adverse Consequences of Mandatory Auditor Rotation? Evidence from the Italian Experience". AUDITING: A Journal of Practice & Theory. 2013, Internet Resource.

Ewelt-Knauer, C., Gold, A., and Pott, C., "Mandatory Audit Firm Rotation: A Review of Stakeholder Perspectives and Prior Research". Accounting in Europe. 10 (1): 2013, 27-41.

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United States. Public accounting firms required study on the potential effects of mandatory audit firm rotation. [Washington, D.C.]: U.S. General Accounting Office, 2003.