carcello and reid - 2014 - investor reaction to the prospect of mandatory audit firm rotation

Electronic copy available at: http://ssrn.com/abstract=2384152 Investor Reaction to the Prospect of Mandatory Audit Firm Rotation Joseph V. Carcello University of Tennessee Lauren C. Reid University of Tennessee January 2014 Acknowledgements: We appreciate the helpful feedback we received from the 2013 AAA Auditing Midyear Conference participants as well as workshop participants at Florida International University and at the University of Tennessee’s Corporate Governance Center. Data Availability: Data are available from public sources identified in the text.! Electronic copy available at: http://ssrn.com/abstract=2384152 Investor Reaction to the Prospect of Mandatory Audit Firm Rotation SUMMARY: The PCAOB is currently considering the implementation of mandatory audit firm rotation in hopes of better aligning auditors’ interests with investors’ interests. The PCAOB also recently proposed a standard that would require disclosure of auditor tenure in the audit report. These actions seem to indicate that the PCAOB views long auditor tenure as problematic. However, the accounting profession argues that long tenure actually improves audit quality. This study provides insight into investors’ views by evaluating the market’s reaction to multiple events related to the potential adoption of rotation. The results reveal that the market reacts negatively to the prospect of forced rotation. In particular, the market reacts more negatively if the current auditor is an industry specialist or a Big 4 firm. The reaction is also more negative if the company has high audit quality proxied via abnormal accruals. Moreover, the market’s reaction is more negative given longer auditor tenure. Keywords: mandatory audit firm rotation; market reaction; PCAOB; investor perception. 1 I. INTRODUCTION “[I]n recent years, we have seen an equally significant spike in deficiencies. Year in, year out, inspectors find deference to management in key reporting areas. For example, in the critical area of fair value reporting of financial instruments, instead of skeptically testing the reasonableness of managements’ assumptions and resulting assertions, one firm’s method involved obtaining valuations from a number of external parties and picking the one that is, ‘closest to the pin’ – the pin being management’s claimed value. … the explicit acknowledgement that the test was designed to support management’s number – the ‘pin’ – calls into question whether the auditor approached the audit with appropriate skepticism.” (PCAOB Chairman James Doty 2012). As a result of the Public Company Accounting Oversight Board’s (PCAOB or Board) concern about auditors’ lack of professional skepticism, the Board has reopened a debate that began over thirty years ago and is considering whether indefinite tenure aligns the auditors’ interests with management rather than guarding investors’ interests. One commonly recommended solution to this issue is mandatory audit firm rotation. 1 In addition, given that the U.S. House of Representatives has expressed its opposition to mandatory firm rotation (Tysiac 2013), the PCAOB may be implicitly encouraging firm rotation by proposing that audit firm tenure be disclosed in a revised version of the standard audit report (PCAOB 2013). Disclosure of long audit firm tenure is likely to attract adverse publicity and unwanted attention and perhaps indirectly spur audit firm rotation, accomplishing what the PCAOB may not achieve through direct rulemaking. Regardless of the PCAOB’s rulemaking efforts related to audit firm tenure and auditor reporting, mandatory firm rotation has been the focus of regulatory scrutiny for many years 2 and will likely to continue to be of interest to regulators (DeFond and Zhang 2013). 1 Other audit regulators are examining the issue of mandatory firm rotation as well. The U.K.’s Competition Commission decided against requiring mandatory audit firm rotation, but will instead require the U.K.’s largest companies to retender their audit engagement at least once every 10 years (U.K. Competition Commission 2013). In addition, the European Parliament’s Legal Affairs Committee recently voted to require audit firm rotation once every 14 years (Singh 2013). 2 The current discussion is not the first time mandatory firm rotation has been a regulatory debate in the United States. The Metcalf Committee formed by the U.S. Senate in 1976 issued a report noting the independence issues created by long auditor tenure and suggested that “one alternative is mandatory change of accountants after a given 2 Proponents argue that mandatory audit firm rotation results in management being less able to influence auditors’ decisions and auditors being less inclined to issue reports that favor management (Ruiz-Barbadillo et al. 2009). Another common argument for mandatory audit firm rotation is that a new auditor provides a “fresh look” at the company and its financial reporting (Lu and Sivaramakrishnan 2009). This different perspective can also improve audit quality and enhance independence. On the other hand, some argue that the loss of in-depth knowledge of the client and its industry reduces the effectiveness of the audit (Lu and Sivaramakrishnan 2009). Opponents of forced rotation also believe that audit firm rotation is unnecessary as appropriate safeguards are already in place, including audit partner rotation, audit committee independence, peer reviews, the normal turnover of engagement teams, threat of audit firm reputation loss, and risk of audit firm litigation (GAO 2003; Ruiz-Barbadillo et al. 2009). Opponents also cite academic literature on auditor tenure that generally finds that long audit tenure improves audit quality (DeFond and Zhang 2013), albeit in a regime where audit firm turnover is voluntary not mandatory. Some of this research notes that audit quality suffers during the early years of the client relationship and leads to more instances of fraudulent financial reporting (Geiger and Raghunandan 2002; Carcello and Nagy 2004). Mandatory audit firm rotation has received increased attention within the United States in recent years as the PCAOB initiated a discussion regarding the possible adoption of rotation and commenced the process of examining its merits and drawbacks. While it is impossible to gather U.S. archival evidence on the effects of a potential policy, it is feasible to study whether or not investors might value the policy (Zhang 2007; Li et al. 2008; Armstrong et al. 2010; Joos and Leung 2013). Generally following the approach used in Armstrong et al. (2010) and Joos and period of years” (U.S. Congress 1976). In 1978, the AICPA issued the Cohen Commission Report, which dismissed mandatory rotation for the time being (AICPA 1978). Then, during the deliberations surrounding the passage of the Sarbanes-Oxley Act in 2002, the requirement to rotate audit firms was seriously considered once again. 3 Leung (2013), we examine the U.S. stock market reaction to several events that affect the likelihood that the PCAOB will adopt a mandatory audit firm rotation policy. This research design allows us to measure the expected net benefits to the group, investors, that the policy is designed to benefit (DeFond and Zhang 2013). Furthermore, the PCAOB received well over 600 comment letters in response to its Concept Release on audit firm rotation (Franzel 2012), but less than ten percent were from investors and their responses were mixed. Therefore, it remains an empirical question as to whether investors support or oppose mandatory audit firm rotation. In addition to testing for an overall stock market reaction, we primarily investigate if the market reaction differs based on firm and auditor characteristics. The results of this analysis may be particularly informative to the Board as they reveal the possible triggers of investors’ reactions to the prospect of mandatory audit firm rotation. Overall, we find evidence of a significant and negative market reaction to six prominent events affecting the likelihood that a mandatory audit firm rotation policy is adopted in the U.S., suggesting that investors, on average, oppose forced rotation. Specifically, the mean cumulative abnormal return across the rotation event dates is -0.0169, where the cumulative abnormal market return is calculated using an index of foreign stock returns since these firms would have been less effected by the PCAOB’s discussion of mandatory firm rotation. We do not have a U.S specific control group because the PCAOB’s discussion of audit firm rotation included all SEC registrants. Therefore, given the lack of a U.S specific control group, we focus primarily on our cross-sectional tests. 3 We examine whether there is a differential market reaction based on audit firm industry specialization, audit firm tenure, Big 4/non-Big 4 dichotomy, and audit 3 We relax this assumption in the robustness section where we create a U.S specific quasi control group using non- accelerated filers as a group that may not be effected (or at least would be less effected) by any PCAOB audit firm rotation policy. 4 quality as proxied by abnormal accruals. Based on these cross-sectional tests of auditor characteristics, we find that firms with an industry expert as an auditor experience a significantly more negative market reaction than firms without an expert auditor. We also find evidence that the market reaction is significantly more negative for firms with long auditor tenure compared to firms with shorter auditor tenure. Furthermore, companies audited by Big 4 accounting firms react more negatively to the discussion of mandatory rotation compared to companies audited by non-Big 4 firms. In addition, our results suggest that companies receiving a high quality audit from their current auditors experienced a significantly more negative market reaction compared to companies receiving a lower quality audit. Our results are generally consistent with those in a contemporaneous work by Gerakos and Syverson (2013) who find, using a fundamentally different methodology, that a policy of mandatory firm rotation would result in consumer surplus losses of approximately $2.4 – 3.6 billion given the existing level of audit fees. Furthermore, we utilize non-event day returns as an alternative benchmark to test the significance of our overall market and regression results. Using a similar procedure to Armstrong et al. (2010) and Joos and Leung (2013), we calculate cumulative market-adjusted returns for three consecutive trading days that are not captured in our event windows. We then compare the mean market-adjusted returns across our event windows to the mean non-event returns to test the significance of the overall market reaction. In our cross-sectional tests, we estimate additional regressions replacing the market-adjusted returns of our event windows with the non-event day market-adjusted returns as the dependent variable. We compare the coefficients from the non- event regressions to the coefficients obtained in our main model to test the significance of our variables of interest. This procedure ensures that our results are not a product of systematic relationships between our test variables and cumulative abnormal returns in any three-day 5 window, but rather are specific to the event windows and therefore the prospect of mandatory audit firm rotation. This study contributes to the debate on firm rotation by providing the PCAOB and other regulators with relevant and timely information regarding the market reaction to the prospect of mandatory rotation. As regulators are considering the implementation of this regime in order to protect investors, it is interesting to note the negative market reaction to the possibility of mandatory auditor rotation. It appears that investors respond negatively to the discussion of mandatory rotation as they value the expertise of their current auditor and perhaps believe that any potential benefits of rotation, such as improved independence, would likely be outweighed by its costs. It also appears that investors view rotation as especially undesirable for companies utilizing an industry expert or Big 4 auditor, and companies that have a longer relationship with their audit firm. In addition, this study indicates that investors are more opposed to forced rotation if firms are receiving high quality audits from their current auditor. These results suggest that investors have reservations about the possible implementation of rotation for certain firms and that a one-size-fits-all approach might not be appropriate should audit regulators continue to explore the prospect of mandatory audit firm rotation. The remainder of the paper is organized as follows. Section II provides further background on mandatory audit firm rotation and develops our hypotheses. Section III describes our research method, and Section IV presents our results and robustness tests. The last section discusses limitations and concludes. II. BACKGROUND AND HYPOTHESES PCAOB Consideration of Mandatory Firm Rotation and Event Dates of Interest 6 The possibility of mandatory firm rotation was discussed when Congress was drafting the Sarbanes-Oxley Act (SOX) of 2002. However, Congress determined that more research was needed to see if audit partner rotation, among numerous other measures, was sufficient in addressing independence concerns. Therefore, Section 207 of SOX commissioned the General Accounting Office (GAO) to study mandatory firm tenure limits. 4 In 2003, the GAO issued a report stating that the SEC and PCAOB would need several more years to determine whether or not the SOX reforms provided enough protection for investors against entrenched audit firms. The GAO concluded that audit firm rotation ‘‘may not be the most efficient way to strengthen auditor independence and improve audit quality’’ (GAO 2003). 5 Over the past eight years, the PCAOB has conducted almost two thousand audit firm inspections (Hanson 2012) and has found several hundred audit failures (Doty 2011). The continuing inspection problems found by the PCAOB have prompted the Board to revisit whether audit firm rotation would improve audit quality. As stated previously, PCAOB Chairman Doty has expressed concern that long auditor- client relationships can create an incentive to please the client. This perverse motivation clouds the auditors’ judgment and can cause a lack of professional skepticism as well as a failure to obtain sufficient audit evidence. On June 2, 2011, Doty publicly stated his belief that steps need to be taken to shift the auditors’ “mindset to protecting the investing public”. In his speech, he notably remarked that “it is incumbent on the PCAOB to take up the debate about firm tenure and examine it, with rigorous analysis and the weight of evidence in support and against [it]” (Doty 2011). Doty also announced the PCAOB’s plans to issue a concept release in the near 4 The name of the General Accounting Office has changed to the Government Accountability Office, but we refer to this group using the name in effect at the time the study was issued. 5 We conduct a basic event study around the November 21, 2003 GAO report issuance and find a 0.28 percent cumulative abnormal market return in the (0,+1) window and 0.35 percent cumulative abnormal return in the (0,+2) window. Both returns are significant at the 1 percent level. These positive abnormal returns provide some indication that investors were pleased with the GAO’s conclusion that mandatory audit firm rotation was not the most viable option to improve audit quality. 7 future to formally explore rotation. As the Chairman’s speech was the first significant statement regarding the PCAOB’s consideration of mandatory rotation since the drafting of the Sarbanes- Oxley Act of 2002, we classify June 2, 2011 as our first event date that increases the likelihood of adoption. On August 16, 2011, the PCAOB issued a Concept Release to solicit public comment on ways to enhance auditor independence, skepticism, and objectivity, including the possible introduction of a mandatory audit firm rotation policy (PCAOB 2011b). The Concept Release presented numerous questions regarding the benefits and costs of mandatory audit firm rotation and also requested input as to how such a policy would be implemented. We classify the issuance of the Concept Release as our second event that increases the likelihood of mandatory rotation. The third event occurred on September 23, 2011 when PCAOB Member Jay Hanson spoke at the SEC Financial Reporting Conference. Since the issuance of the Concept Release, it was the first time a board member made public comments regarding mandatory audit firm rotation. Hanson stated his belief that “the Board should proceed cautiously along the path toward mandatory auditor rotation.” He explained several of his concerns, including increased financial costs, decreased audit quality in the first years of a new engagement, and the possibility that “auditor independence could suffer in a mandatory rotation framework, because audit firms may step up their marketing of non-audit services to audit clients near the end of the permissible term of the audit engagement” (Hanson 2011). As this event represents a Board Member’s hesitation regarding mandatory firm rotation, we view this event as a decreasing the likelihood of policy implementation. 8 On October 4, 2011, Board Member Daniel Goelzer also publicly voiced his concerns regarding forced rotation. He expressed that he has “serious doubts that across-the-board mandatory rotation is a practical or cost-effective way of strengthening independence” (Goelzer 2011). Goelzer mentioned only requiring rotation in special cases such as when a PCAOB inspection report cites a professional skepticism issue (Goelzer 2011). We view this fourth event as also decreasing the likelihood of rotation, especially because two of the five Board members had essentially indicated their opposition to rotation by this point. The last two events included in our study involve a Congressional proposal to prohibit the PCAOB from mandating audit firm rotation. On March 23, 2012, the House of Representatives announced a hearing to be held on March 28 th by the Committee on Financial Services to discuss an amendment to SOX that Representative Michael Fitzpatrick of Pennsylvania proposed (Whitehouse 2012; U.S. House 2012). This amendment would preclude the PCAOB from implementing any regulation that requires auditors to be rotated. We classify the March 23 rd announcement and the March 28 th hearing as events that decrease the likelihood of rotation. 6 Evidence in Favor of Mandatory Audit Firm Rotation Proponents of mandatory audit firm rotation argue that long tenure impairs the independence of the auditor. This argument is grounded in the theory developed by DeAngelo (1981), which states that a client provides the audit firm with an annuity of quasi-rents that it expects to receive throughout its relationship with the client. This incentivizes the auditor to make sacrifices in order to maintain the client relationship and guarantee its annuity, which can diminish auditor independence (DeAngelo 1981). 6 The U.S. House of Representatives approved a bill that would preclude the PCAOB from implementing mandatory firm rotation on July 8, 2013 (Tysiac 2013). We do not separately analyze this date because by early July 2013 it was obvious to informed observers that the House of Representatives was opposed to firm rotation, and given that the Senate has no immediate plans to consider this bill, it is not obvious that the House vote provides any meaningful incremental information over what was already known as of March 2012. [...]... meetings, and other announcements pertaining to mandatory firm rotation We also used Factiva to search for other news related to the mandatory rotation debate in the United States 7 Of these six events, we view the first two events as increasing the likelihood of implementing mandatory audit firm rotation and the remaining four events as decreasing the likelihood of implementing mandatory rotation Table... competing auditor bids and holding several stages of interviews (Xerox 2012) On the other hand, mandatory audit firm rotation may provide benefits to firms and investors by potentially improving audit quality Comment letters in favor of rotation cited that audit quality would increase due to the fresh perspective provided by new auditors and the improvements in auditor independence, objectivity, and professional... Wang and Tuttle (2009) perform an experiment to test the impact of rotation on the negotiation process between clients and auditors The authors discover that in the absence of mandatory firm rotation, auditors are more concerned with appeasing management and tend to use “obliging” strategies in negotiation whereas with a mandatory rotation regime, auditors are not motivated by their need to maintain the. .. results indicate that the market generally reacted negatively to the possibility of mandatory firm rotation, and the negative reaction was most pronounced for firms currently receiving high audit quality and, contrary to the concerns about long auditor tenure, for those firms with longer auditor tenure Given the long-standing interest in auditor rotation by policymakers, and the current interest in... partition the sample in four different fashions and test the differences in stock market reaction for firms: (1) with an industry expert as the auditor and firms without an industry expert as the auditor, (2) with long auditor tenure and short auditor tenure, (3) audited by a Big 4 accounting firm and firms audited by a non-Big 4 accounting firm, and (4) currently receiving a higher quality audit compared to. .. context to test the effects of the rotation requirement on auditor independence By examining auditors’ likelihood to issue going-concern opinions to financially distressed firms during and after the mandatory rotation period, Ruiz-Barbadillo et al (2009) find that the required rotation did not affect auditors’ incentives Specifically, the authors discover that, regardless of the regulation, auditors are... I Khurana, and K Raman 2008 Audit firm tenure and the equity risk premium Journal of Accounting, Auditing, and Finance 23 (1): 11 5-1 40 Carcello, J., and A Nagy 2004 Audit firm tenure and fraudulent financial reporting Auditing: A Journal of Practice and Theory 23 (2): 55–69 Casterella, J R., and D Johnston 2013 Can the academic literature contribute to the debate over mandatory audit firm rotation? ... Selective mandatory auditor rotation and audit quality: An empirical investigation of auditor designation policy in Korea Working paper Comunale, C and T Sexton 2005 Mandatory auditor rotation and retention: Impact on market share Managerial Auditing Journal 20 (3): 23 5-2 48 Craswell, A T., J R Francis, and S L Taylor 1995 Auditor brand name reputations and industry specialization Journal of Accounting and. .. market reacted mostly to events outside of the mandatory firm rotation discussion Given the potentially far-reaching effects of adopting a policy of mandatory firm rotation, it is important to consider the market implications of such a policy We provide the first evidence 31 as to how the U.S stock market reacted to events that either increased or decreased the likelihood that a rotation policy would... Overall, the literature on auditor tenure is frequently cited in the mandatory firm rotation debate, but it remains difficult to disentangle the impact of tenure on audit quality and independence Lim and Tan (2010) argue that the conflicting conclusions may be attributable to the failure to consider the effects of auditor expertise and fee dependence The authors find that with long auditor tenure, audit . likelihood of rotation. 6 Evidence in Favor of Mandatory Audit Firm Rotation Proponents of mandatory audit firm rotation argue that long tenure impairs the independence of the auditor. This. characteristics. The results of this analysis may be particularly informative to the Board as they reveal the possible triggers of investors’ reactions to the prospect of mandatory audit firm rotation. . implementation of rotation for certain firms and that a one-size-fits-all approach might not be appropriate should audit regulators continue to explore the prospect of mandatory audit firm rotation. The