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.

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.

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One response to “Auditor Rotation Rules Miss Their Mark”

  1. I totally disagree with the findings and conclusion of this article. This article is clearly written by academics with no auditing experience. I have over 40 years as an auditor with a Big 4 firm and been through numerous transitions with clients both as a new partner rotating on to a long time client as well as serving many new clients where we took the work from another firm. The relatively low %’s of error duration and impact of tenure are so small they are meaningless. If one were to look at the details of these findings my hunch would be there would be noticeable differences in these findings between small to mid size companies vs. say Fortune 1000 size companies. I would also say the nature of audit quality is MUCH higher when a firm has long term relationship and accumulated knowledge of the company’s business/industry, audit committee and senior management culture and commitment to doing the right things than anything to do with tenure of the audit firm. I also firmly believe that a significant factor is the years of experience and technical competency of the partner as well as industry knowledge that has MUCH more impact on audit quality than rotating audit firms. From personal experience I know that as new auditor there is MUCH to learn and it truly takes several years (for larger companies) to totally understand the business, controls, systems, management competency so the risk is much higher for new auditor error and oversight to miss misstatements. Someone should do a study as to how long before a new auditor is assigned to when the first misstatement surfaces and how far back did the misstatement go. Also, look at the stats of how many misstatements are even surfaced at all during the first 10 years of a newly appointed firm (I would expect very rate and if misstatement is identified it is for a current or recent year misstatement than one that existed for several years back to more tenured audit firm). I am highly suspicious and challenge these findings and would be happy to participate in a discussion debating these findings. Furthermore, why doesn’t such a study include interviews with audit committee and board members as to their experience with auditor quality as to partner rotation vs. firm tenure and I think you would clearly find that audit committees, board and senior management would clearly vote on the side that audit quality does NOT rely or depend upon auditor rotation and that auditor industry and cumulative knowledge passed on over the years from audit partner to audit partner and their audit teams are the KEY factors driving audit quality MUCH more so than audit firm tenure. As for Wells Fargo and KPMG, it is well known and has been for several decades that KPMG’s audit quality has been weak/the lowest amongst the big 4 since the 60’s and 70’s. I graduated from college in 1976 and it was very easy as I interviewed with Big 4 (actually Big 8 at the time) that KPMG had by far the most litigation cases in the profession and as I interviewed with KPMG they clearly appeared to me to have the least commitment to continuing education of their staff by farming out to local colleges or professors to teach their CPE. The in-house training programs developed by the firms and taught by their experienced professionals as to their firm’s specific audit methodology was by FAR superior to the outsourced training. Why don’t the people who do these surveys and studies interview and talk to some of us experienced veterans in the trenches more to get better insights as to audit quality conclusions than doing their studies in a sterile environment looking at just the stats like those quoted in this article. Very disappointing and very blindly bias findings and conclusions.

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