Risk & Compliance

Auditor Rotation Rules Miss Their Mark

Merely requiring companies to periodically invite bids for their audit business, or change engagement partners at the incumbent firm, doesn't do th...
David McCannFebruary 28, 2018
Auditor Rotation Rules Miss Their Mark

Last year, in a pointed footnote to the scandal enveloping Wells Fargo, two major pension funds opposed ratification of the company’s external auditor and called on Wells Fargo to explore changing audit firms.

Yet, the bank’s 85-year relationship with the auditor continues today despite the objections of the two large shareholders, not to mention protests from two U.S. senators over the audit-firm’s “failure to publicly identify the Wells Fargo scandal or its risk to investors.”

Thus has returned to the fore an issue that has roiled corporate auditing in recent decades: whether regulators should force public companies to change auditors periodically, and, if so, how often.

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Regulators in both the United States and Europe have responded to calls for mandated auditor rotation. In 2014, the European Union (EU) required companies to invite bids from other auditors after 10 years. In the United States, the Sarbanes-Oxley Act of 2002 mandated rotation after five years of the principal engagement partner overseeing a corporate client’s audits (but did not demand rotation of the audit firm).

How effective are these mandates in fostering high-quality audits that investors can count on? Both fall short in critical ways, concludes a scholarly paper in the March issue of The Accounting Review, a peer-reviewed journal of the American Accounting Association.

The study, by Zvi Singer of HEC Montreal and Jing Zhang of the University of Alabama in Huntsville, casts doubt that audit-partner rotation, as mandated by SOX, is a sufficient substitute for audit-firm rotation. “Overall, the results indicate that SOX did not eliminate the negative effect of long auditor tenure on audit quality,” the professors conclude.

As for the E.U.’s mandate that companies seek offers from other accounting firms after 10 years of auditor tenure, the new study finds that 10 years is actually about the point where the ill effects of long tenure recede. “Beyond 10 years of auditor tenure, the association between auditor tenure and misstatement duration is insignificant,” the authors explain.

In reaching these conclusions, the study arrives at a more skeptical view of lengthy auditor tenure than generally prevails in scholarly literature or among key players in the investment world. The latter reward lengthy auditor tenure with lowered corporate borrowing costs, enhanced responses to earnings reports, and boosts in stock ratings.

“The common conclusion of prior studies,” Singer and Zhang write, “is that short auditor tenure leads to low financial-reporting quality because the new auditor lacks the client-specific knowledge accumulated over time. However, an alternative interpretation is that low financial-reporting quality leads to short auditor tenure … because the auditor and the client are more likely to run into disagreements.”

To avoid such confusion as to what is cause and what is effect, the research focuses exclusively on serious accounting errors that occur and are corrected during the tenure of the same auditor (meaning that tenure precedes the problem).

Drawing on data involving 3,465 corporate misstatements by U.S. companies during a 14-year period, the professors investigate how length of tenure affects auditors’ speed in coping with misstatements.

In about 35% of these cases, misreporting occurred in only a quarterly statement but not in the subsequent annual financial report, suggesting laudable auditor vigilance and high audit quality. In the remaining instances, misstatements occurred in at least one annual report that auditors signed off on, with longer duration signaling lesser auditor vigilance and lower audit quality.

The heart of the study is analysis of the relationship between auditor tenure (years from hiring date to misreporting) and “misstatement duration” (the length of time from the first misstated annual report that the auditor signed and the client’s issuance of a restatement).

Auditors with shorter tenures are faster to discover financial misreporting, the authors write. For example, when auditor tenure was three years or less, the average misstatement duration was a little less than a year. Where tenure was 11 or more years, average duration was about a year and a half.

To corroborate these findings, Singer and Zhang ingeniously take advantage of a natural experiment in which a select group of companies were forced to change an external auditor, as happened with the 2002 downfall of major accounting firm Arthur Andersen.

Investigating Andersen clients’ financial reporting in the years preceding and following the accounting firm’s collapse, the professors focus on accounting misstatements that started under Andersen and ended after the forced switch to another auditor.

Comparing the duration of those misstatements with those of companies that retained a single Big 4 auditor over that same span, the professors find that the latter lasted on average 15% longer. That statistically significant difference leads them to cite this as further evidence of the beneficial effect of a new auditor’s fresh view.

It is by applying their novel research methods to assess the current U.S. and EU current rotation requirements that the professors discover the mandates’ serious shortcomings.

Since their data extends from before Sarbanes-Oxley to well after its passage, they are able to gauge SOX’s effect on the relationship between auditor tenure and audit quality (as proxied by misstatement duration). They find that, although the legislation reduced the negative effect of lengthy tenure by about 50%, the effect has remained significant.

To assess the E.U. rotation mandate, they divide the 3,465 companies in their primary sample between those that retained their audit firm for up to 10 years and those that retained them longer.

Up until 10 years, they find that a one-year increase in auditor tenure increases the misstatement duration by approximately 2.02%, so that on average, misstatement duration is 18.18% longer after 10 years of auditor tenure than after one year.

Beyond 10 years of auditor tenure, the association between auditor tenure and misstatement duration is insignificant.