raiborn et al - 2006 - should auditor rotation be mandatory

I n response to the widespread and financially devas- tating business scan- dals (Enron, Adelphia, HealthSouth, and WorldCom, to name just a few) that took place during 2001 and the first half of 2002, Congress passed the Sarbanes-Oxley Act (SOX) on July 30, 2002. This act was designed to address accounting reform, improve cor- porate governance, and restore investor confidence. The depth and breadth of SOX’s legislative coverage provide a basis to sup- port broad reform within the auditing profession. Within Title II (“Auditor Independence”) of the Act is a small, three-para- graph section that has the poten- tial to change the way the audit- ing profession interacts with client companies. Section 207 of the Act required a study of the potential impacts of requiring mandatory rotation of audit firms for pub- licly held companies. In Novem- ber 2003, the Government Accountability Office (GAO) delivered the results of this study to the Senate Committee on Banking, Housing, and Urban Affairs and to the House Com- mittee on Financial Services. This article discusses the study and several audit firm/client company issues related to the potential for mandatory rotation. AUDITOR INDEPENDENCE Although the first audit cer- tificate was issued in 1903 for financial statements of U.S. Steel Corporation, it was not until early 1934 that a booklet titled Audits of Corporate Accounting was published (Davidson & Anderson, 1987). Then, Section 12 of the Securi- ties and Exchange Act of 1934 required registered firms to have their financial statements audit- ed by an independent public accountant: “The auditor was to be an independent overseer of the integrity of information pro- vided to the capital markets, and this role was granted as a public trust to the profession” (Hunt, 1997). The concept of auditor independence has always consisted of two parts: indepen- dence in fact and inde- pendence in appear- ance. Independence in fact reflects a state of mind, while independence in appear- ance reflects an external assess- ment. Both elements of inde- pendence must exist: the public (assuming the reasonable person standard) cannot perceive that an auditor or an audit firm is biased or has conflicting interests with the client company. If indepen- dence in appearance is tainted, the sense of confidence that the audit opinion was designed to engender will be diminished. The financial fiascoes occur- ring in the new millennium caused the investing public as well as Washington lawmakers to take a long look at the issue of auditor independence. Although most audit firms would assert that both aspects of indepen- dence are stressed at all person- nel levels, auditors may find it difficult to interpret the true pri- ority parameters if the firm is sending mixed messages. Audi- The Sarbanes-Oxley Act (SOX) has brought many changes. But buried within SOX is a small, three- paragraph section that could change the face of auditing. The authors discuss mandatory rotation of auditors: the pros and cons, how it might work, and the changes it might bring. © 2006 Wiley Periodicals, Inc. Cecily Raiborn, Chandra A. Schorg, and Morcos Massoud Should Auditor Rotation Be Mandatory? f e a t u r e a r t i c l e 37 © 2006 Wiley Periodicals, Inc. Published online in Wiley InterScience (www.interscience.wiley.com). DOI 10.1002/jcaf.20214 tors must attempt to interpret the rules of professional conduct within the context of their per- ceptions about the audit firm’s objectives relative to client engagements. Is the audit firm’s objective to perform the best audit possible, retain the audit client company, increase audit revenues, reduce audit billable hours, or detect misleading, inap- propriate, or fraudulent account- ing practices? Unfortunately, each of these objectives is rea- sonable—and yet potentially in conflict. For instance, at Arthur Andersen LLP, independence in fact was “an ingrained part of the culture,” but other activities that could have impacted independence in appear- ance were encouraged and were seemingly “undertak- en especially to build inter- dependence with the client” (Toffler, 2003, pp. 187–188). In the Enron case, David Duncan (the lead member of the Andersen audit team for Enron) and Richard Causey (for- mer Andersen employee and then executive VP and chief account- ing officer at Enron) “were virtu- ally inseparable. They worked together, went to lunch together, and played golf together. Their families even went on vacations together” (Squires, Smith, McDougall, & Yeack, 2003, p. 2). Other instances that would cause the questioning of independence at Arthur Andersen included giv- ing tickets to the U.S. Open to clients, buying tables at clients’ favorite charity events, providing summer employment for clients’ children, and sending a limousine to take a client and his daughter to a Yankees game, wait for them, and return them home to the sub- urbs (Toffler, 2003, pp. 125, 188). Sarbanes-Oxley has dramati- cally changed the relationships between auditors and client man- agement. One CFO remarked, “only half jokingly,” that he didn’t consider the auditors his “friends anymore” (O’Sullivan, 2004a). In an attempt to minimize the potential for lack of inde- pendence in appearance (or a true lack of independence in fact), Section 203 of SOX stated that the lead, coordinating, or reviewing audit partner must be rotated from an audit engage- ment every five years. Such a rotation process was designed to reduce the possibility that the audit partner and members of client management would devel- op improper, nonindependent relationships with one another. However, given that professional standards already required such a rotation process, Congress was not certain that mandated partner rotation was sufficient to pre- clude public concerns about audit firm independence—in either fact or appearance—from clients. PARMALAT SpA The issue of mandatory auditor rotation has recently been raised because of numerous cases of financial misconduct by firms in the United States. How- ever, the Italian requirement for auditor rotation did nothing to prevent one of the worst finan- cial scams to date on the Euro- pean continent at Parmalat SpA, a multinational dairy food giant. Prior to the scandal creating losses of about $10 billion, Par- malat had been included in the 30 most valuable companies on the Milan Stock Exchange. Deloitte & Touche of Italy served as Parmalat’s primary auditor between 1999 and Janu- ary 2004; the Italian rotation requirement allows an audit firm to serve as auditor of record for a maximum of nine years, re- competing every three years for the engagement (GAO, 2003). Grant Thornton SpA rotated out of the Parmalat engagement in 1999, after serving as the com- pany auditor since 1990. Accord- ing to one source, the fraud at Parmalat started around 1989 when the company went public and the “auditors never noticed” (Norris, 2003). At the time the Parmalat fraud was dis- covered, Grant Thornton SpA was auditing “Par- malat’s offshore assets, where investigators say the fraud appears to have taken place” (Landler, 2003). In fact, in 2003, Grant Thorn- ton SpA received approximately 2 percent of its total audit fees from auditing Parmalat units— creating a question as to why Italian rules allow an audit firm to continue as a secondary audi- tor after relinquishing its pri- mary auditor position to another firm (Babington, 2004). A law- suit filed by Enrico Bondi, the new Parmalat chairman, states that two partners in the now- former Grant Thornton Italian affiliate “were active conspira- tors with Parmalat’s management in setting up fictitious compa- nies and structuring fake transac- tions . . . to siphon off ” Par- malat’s assets (Norris, 2004). RESULTS OF THE GAO STUDY ON MANDATORY AUDITOR ROTATION In developing the indepen- dence provisions of SOX, testi- 38 The Journal of Corporate Accounting & Finance / May/June 2006 DOI 10.1002/jcaf © 2006 Wiley Periodicals, Inc. The issue of mandatory auditor rota- tion has recently been raised because of numerous cases of financial mis- conduct by firms in the United States. mony to Congress was heard on the positive and negative impli- cations of instituting mandatory rotation of audit firms relative to client companies. Mandatory rotation implies that an explicit limit is placed on the time dur- ing which a specific audit firm may be the auditor of record for a specific client company. The maximum time limit for the rota- tion process has not been indi- cated. Although the issue of mandatory audit firm rotation has previously been investigated (and rejected) by both the Secu- rities and Exchange Commission (SEC) and the Committee of Sponsoring Organizations of the Treadway Commis- sion, the Comptroller Gen- eral of the United States, through the auspices of the Government Accountability Office, was required under Section 207 of SOX to per- form a study about manda- tory rotation. The GAO reviewed research studies and documents, developed and administered sur- veys to public accounting firms and appropriate parties in large public companies, and identified restatements of financial state- ments and cross-checked those with auditor changes. Analyses were made of the arguments contained in the GAO studies and the responses that were gen- erated. The final report was issued in November 2003. Arguments in Favor of Mandatory Auditor Rotation Individuals who support mandatory audit firm rotation contend that pressures faced by the incumbent audit firm to retain the client company could adversely affect the auditor’s actions to appropriately deal with financial reporting issues that materially affect the compa- ny’s financial statements. Con- sider the following simplistic summary of the cooperative rela- tionship between auditor and client: the client corporation engages in and accounts for transactions that create the financial statements; auditors examine the financial statements and the underlying data to assess fair presentation based on the guidance provided under accounting rules and standards; and the desired result of this process is an unqualified audit opinion for the client. The fewer adjustments that need to be made to the financials and the more quickly (thus, less expen- sively) the audit can be per- formed, the more satisfied the client company is with its cho- sen audit firm (and individual employee auditors), the more likely it is that the auditing firm will retain the client and the individual auditors will have continued future employment, and the stronger the auditor- auditing firm-audit client rela- tionship becomes. In other words, “auditors have strong business reasons to remain in clients’ good graces and are thus highly motivated to approve their clients’ accounts” (Bazerman, Loewenstein, & Moore, 2002). A second argument in favor of mandatory audit firm rotation is that it would increase the pub- lic’s perception of auditor inde- pendence—in other words, the element of independence in appearance would be raised. Such a positive perception was a conclusion of the Bocconi Uni- versity Report from Italy, which has a mandatory auditor rotation requirement (Arel, Brady, & Pany, 2005). Prior to the issuance of SOX, discussions of the public’s lowered perception of auditor independence in appearance typically focused on the provision of nonaudit servic- es to client companies. Section 201 of Title II has basically eliminated that concern. Howev- er, it is not unrealistic for the public to be concerned as to the innate impartiality and objectivi- ty that should exist between audit firm and client employees given the instances of out- of-office familiarity that have been made public during the various corpo- rate scandals. Mandatory rotation would provide the basis for a distancing between the parties involved. A third reason in favor of mandatory rotation is that it would allow audit firms to be more vocal about disagreeing with questionable client prac- tices. Knowing that a client com- pany would only “belong” to the audit firm for a limited period of time, the firm would not be risk- ing a perpetual revenue stream by agreeing to overly aggressive practices, deterring questionable judgments, or taking compro- mise positions on recording business transactions (Confer- ence Board, 2003, p. 34). A fourth reason in favor of mandatory rotation is that it would, to a limited extent, help level the playing field for audit firms. The SOX partner rotation and five-year “time out” require- ments are “tantamount to firm rotation” for the smaller firms that are “not large enough to have a substantial number of The Journal of Corporate Accounting & Finance / May/June 2006 39 © 2006 Wiley Periodicals, Inc. DOI 10.1002/jcaf A second argument in favor of mandatory audit firm rotation is that it would increase the public’s percep- tion of auditor independence… partners available to rotate” (American Institute of Certified Public Accountants [AICPA], 2003). Essentially forcing firm rotation among smaller firms provides a distinct advantage to the larger public accounting firms that have the partnership personnel available for rotations into engagements. Thus, manda- tory rotation puts all audit firms on some degree of level footing and could encourage smaller firms to grow and develop niche specializations that would allow greater competition with the Big Four. Fifth, some individuals believe that the costs associated with mandatory rotation would be less than the costs associated with audit failures. For example, Morgan Stanley estimates that the increased cost of mandatory rotation would be approximately $1.2 billion per year, versus the $460 billion loss in market capi- talization caused by the failures of Computer Associates, Enron, Quest, Tyco, and WorldCom (Healey, 2004). The increase was calculated using $10 billion of audit fees in 2000 for the (then) Big Five, a 30 percent increase in audit fees for the first two years, and a rotation period of every five years. Finally, knowing that another audit firm would, at some specif- ic future time, be reviewing the financial statement judgments made by the current audit firm would simultaneously create some internal pressure to be less amenable to potential client manipulations. The successor audit firm would bring “fresh eyes” and limited “relationship baggage” to the engagement— new brooms to sweep away any financial statement fictions that may have been overlooked, ignored, encouraged, or acqui- esced to by a predecessor audit firm. Awareness that the succes- sor auditor might readily identify the lapses of a predecessor audi- tor could reduce the possibility of overlooking accounting irreg- ularities or signing off on con- troversial accounting procedures; obviously, a continuing auditor would be less likely than a new auditor to reverse an accounting position taken in a prior year on a client’s accounting transac- tions. The arguments in favor of mandatory audit firm rotation are summarized in Exhibit 1. Arguments Against Mandatory Auditor Rotation It is no wonder that terms such as client entrenchment, vested interests, and fraterniza- tion have proliferated through the recent corporate audit scan- dals: the GAO survey (2003) indicated that the average auditor tenure at Fortune 1000 public companies was 22 years. The accounting profession and many others abhor the concept of mandatory auditing firm rotation for a variety of reasons. First, those in opposition contend that the new auditor’s lack of knowledge of the compa- 40 The Journal of Corporate Accounting & Finance / May/June 2006 DOI 10.1002/jcaf © 2006 Wiley Periodicals, Inc. Arguments for Mandatory Rotation of Auditing Firms • Decreases the development of friendships and “coziness” between audit firm and client employees • Decreases the potential for auditors to succumb to management pressure to use questionable accounting tech- niques or accept compromised accounting procedures • Increases public perception of auditor independence • Increases the potential for audit firms to be more vocal about disagreeing with questionable client practices • Potentially increases the supply of audit firms that are of the size and have developed the specialized industry expertise to audit the larger publicly held companies in niche sectors • Increases the level of competition among audit firms for clients, which could possibly reduce audit fees • Increases audit quality by providing a “fresh look” at client reporting practices • Increases audit quality because the current audit firm would be aware that a successor auditor would be more likely to detect and disclose predecessor auditor errors or inefficiencies • Increases the possibility that audited firms might reexamine their audit needs and negotiate for more experi- enced auditors on the engagement Exhibit 1 ny’s operations, information sys- tems that support the financial statements, and financial report- ing practices will dramatically reduce audit quality. According to PricewaterhouseCoopers (2002), audit quality depends on numerous factors, ordinarily including “the experience, integrity, and training of the auditors and the firm with which they are associated; their inde- pendence and objectivity; their knowledge of professional stan- dards; and their knowledge and understanding of the company being audited and the industry in which it operates.” The issue of audit quality was specifically addressed in an AICPA Statement of Position (1992), which discussed the substantial learning curve that is needed for auditors to become not simply acquainted or con- versant with, but accom- plished in the corporation’s operating environment, risks, and technical accounting policies and procedures. It is estimated that two to three years on an engagement are necessary for an auditor “to understand fully the business, procedures, and nuances of a complex client” (Terry, 2002). This factor is especially important when the company being audited had numerous domestic and/or for- eign locations. A logical exten- sion of the 2001 Report of the Review Group on Auditing in Ireland comment that “audit quality would be detrimentally affected by the removal of expe- rienced personnel from the audit team” is that audit quality would be even more greatly affected by a change in the entire audit team that would occur through manda- tory rotation (Institute of Char- tered Accountants in England & Wales [ICAEW], 2002). One study of business failures between 1996 and 2001 conclud- ed that a company’s risk of audit failure increased with each change in auditing firm and that there was a reduction in audit quality when a new auditor was unfamiliar with the client’s busi- ness or operations (George, 2004). However, a different study concluded that increased audit tenure does not lead to reduced audit and earning quali- ty (Myers, Myers, & Omer, 2003, p. 798). The learning curve issue is a primary causal factor in the sec- ond reason against mandatory rotation: an increase in costs within the audit firm so that per- sonnel can get “up to speed” on engagement issues and a corre- sponding increase in audit fees for the client company to com- pensate for the additional audit staff time. In the past, an audit firm might have set the first-year audit fee at an “average” level, in anticipation of the long-term revenue stream from the client, rather than attempting to cover true costs of the new engage- ment. Costs of familiarizing audit personnel with the new client and its practices will now be spread out over the shortened rotation period (rather than the average 22-year tenure) and would, therefore, have to cause an increase in billed audit fees. Third, the learning curve is also cited as a crucial source of increased risk of audit failure in the initial years of an audit engagement, during that time needed to acquire the knowledge of financial reporting issues that could materially affect the client company’s financial statements. This audit risk potential, in and of itself, creates an extremely negative cost/benefit relationship in the eyes of both audit firms and client companies. In addi- tion to the accounting matters that create audit risk, there are also risk factors created by the organizational change that has occurred. Regardless of the fact that audit personnel are not an internal part of the client compa- ny, relationships have been established between individuals. The client employees must attempt to form new per- sonal linkages with mem- bers of the incoming audit firm and establish the same level of trust that existed with staff of the predecessor audit firm. In all instances of relationship change, there is a high potential for misunderstanding, uncertainty, and ambiguity—all of which could have critical impacts on the level of audit risk. A fourth reason against mandatory rotation relates to the number of audit firms that have the quantity of personnel, depth and breadth of industry exper- tise, or merely the name recogni- tion to satisfy large domestic and international client companies. There are approximately 18,000 domestic and foreign entities registered with the SEC, and, as of 2001, the current Big Four public accounting firms audited approximately 10,500 of those registered companies. The remaining public companies were audited by almost 700 accounting firms (GAO, 2003). If a publicly held company wants to continue to be audited by a Big Four firm and, because of The Journal of Corporate Accounting & Finance / May/June 2006 41 © 2006 Wiley Periodicals, Inc. DOI 10.1002/jcaf In all instances of relationship change, there is a high potential for misunderstanding, uncertainty, and ambiguity… SOX, is precluded from hiring a firm that is performing specified nonaudit services, the choice is extremely limited. After deciding in December 2004 to dismiss KPMG as its outside auditor, Fannie Mae was basically left with two choices (Deloitte and PricewaterhouseCoopers) for its new auditor, because Ernst & Young (E&Y) has been advising Fannie Mae’s audit committee and management in response to various government probes. This situation “highlights the account- ing profession’s increasingly fragile state of affairs” and the “dwindling choices available to large corporate clients” (Weil, 2004b). Although this auditor change was volun- tary on the part of Fannie Mae, a similar outcome would result from manda- tory audit firm rotation. Additionally, since Sar- banes-Oxley was enacted, Big Four accounting firms are “shedding clients at almost three times the rate they did in 2002,” generally those clients that are “too small to be worth the extra work” and “those judged too risky to work with under the new accounting rules” (Browning, 2005). Given this scenario, there might be few firms willing to accept the rota- tion onto a new client engage- ment. Fifth, those opposed to mandatory rotation point to the fact that the new Sarbanes-Oxley independence and partner- rotation requirements have not had a reasonable amount of time to be fully implemented. Until the full effects of such imple- mentation can be assessed, “it would be premature to impose mandatory audit firm rotation at this time” (GAO, 2003). Sixth, even without compul- sory rotation, new hires and the normal attrition of personnel within a given auditing firm will cause the audit team on an engagement to change over time. These factors, combined with partner rotation, should help provide the periodic fresh perspective on an audit engage- ment that is desired by the investing public. Seventh, the potential shift- ing of auditors from one client to another is a reason against mandatory rotation. Many audit firm respondents to the GAO survey indicated that they would shift “their most knowledgeable and experienced audit person- nel” from a current engagement to another audit as the end of the rotation period neared—even though they believed that re- assigning these individuals “would increase the risk of an audit failure” (GAO, 2003). Several other justifications have been made against enforced rotation. Mandatory rotation might minimize attempts at con- tinuous improvement efforts because the audit firms would be aware that client retention would soon end, thus minimizing or negating any investment effect. Mandatory auditor rotation might result in “opinion shop- ping” among the audit firms. And mandatory rotation might create, in the minds of the pub- lic, a negative perception or “red flag” toward the company engaged in the change. This rea- son, however, does not appear to hold much credibility. Although such a perception is fairly com- mon when firms change auditors in the current business environ- ment, most of the Fortune 1000 company respondents to the GAO survey did not believe this perception would be continued if the rotation process were made mandatory. Finally, there is the issue of global credibility. At present, mandatory audit firm rotation for public companies is required only in Italy and Brazil; Singa- pore requires audit rotation for banking engagements. Italy’s requirement was introduced in 1975 and Brazil’s in 1999. Canada, Spain, Austria, and Greece previously had mandato- ry rotation requirements for auditors, but these countries have revoked such laws, citing an increase in audit cost and a lack of cost effectiveness, as well as achieving a stat- ed objective of increasing audit service competition. The Italian experience has pro- vided evidence that mandatory rotation “increases costs to busi- nesses, creates problems with audit quality in the period immediately after the change of audit firms, and leads to further consolidation of audit work amongst the largest audit firms” (Wyman, 2005). The arguments against mandatory audit firm rotation are summarized in Exhibit 2. After hearing arguments on both sides of mandatory audit firm rotation, the GAO report indicated that audit firms, client companies, and managers of audited companies must have a reasonable amount of time to adjust to the numerous changes that were mandated by Sarbanes- Oxley. Surveys by the GAO of the largest public accounting firms and the Fortune 1000 pub- licly traded companies indicate 42 The Journal of Corporate Accounting & Finance / May/June 2006 DOI 10.1002/jcaf © 2006 Wiley Periodicals, Inc. …the potential shifting of auditors from one client to another is a rea- son against mandatory rotation. that both believe that the costs of mandatory audit firm rotation are likely to exceed the benefits. Thus, the GAO decided the most practical strategy at the time of the report’s issuance was to let the Securities and Exchange Commission and the Public Company Accounting Oversight Board observe and assess the ramifications and effectiveness of the new SOX requirements. CULTURE CHANGES IN AUDIT FIRM AND AUDIT CLIENT RELATIONSHIPS The independence provisions of Title II of SOX will affect how audit firms interact with their clients as well as how audit clients interact with the audit firms—and the changes to these interactions will affect the culture of these entities. Some of these changed interactions have now been man- dated by law; others may be legal- ly mandated in the future. But many of these issues (summarized in Exhibit 3) can simply be viewed from a customer relation- ship management (CRM) per- spective. While often associated with technology applications and substantial investments in detailed databases, the goal of CRM is to allow a company to gain a better understanding of customers in order to serve them more effi- ciently and effectively. In addressing some CRM issues between audit firms and audit clients, two points must be clarified. First, the audit client is not the true customer of an audit firm. After the 1929 stock mar- ket collapse, accountants “acquired a legally defined social obligation—to assist in creating and sustaining investor confidence in the public capital markets” (Previts & Merino, 1979, p. 245). This viewpoint was expressed in a slightly dif- ferent manner in 1974 by Harvey Kapnick, then-Chairman of Arthur Andersen & Co., who stated that accountants “are accountable not to management, not to government regulators, The Journal of Corporate Accounting & Finance / May/June 2006 43 © 2006 Wiley Periodicals, Inc. DOI 10.1002/jcaf Arguments Against Mandatory Rotation of Auditing Firms • Increases audit risk and potential for audit failure because the new audit firm is less familiar with client practices • Increases audit costs because the new audit firm must become familiar with client practices; such costs would be passed along to the client company through increased audit fees • Increases selection and support costs to the client company; such costs would reduce company profitability and shareholder value • Decreases the level of open communications between the audit firm and client employees who are not familiar with one another • Limited number of available audit firms of the size or with the industry expertise necessary to perform client engagements; the lack of competition could create higher audit fees for the client company • Limited number of available audit firms that are not performing restricted nonaudit services for the client • Increase in the possibility that the new audit firm may be overly aggressive in challenging the predecessor audi- tor’s judgments because the new firm is less familiar with client operations; such challenges could, in turn, increase the tension between the new audit firm and the client • Possibility that the audit firm may rotate its most qualified audit staff off the client engagement in years close to the mandatory rotation date and place those staff members on new client engagements • Possibility that the audit firm might begin focusing on marketing nonaudit services to the client in years close to the mandatory rotation date rather than concentrating on providing the highest-quality audit services • Difficulty in resolving issues such as the maximum number of years prior to mandatory rotation, the number of years before a firm could recompete for an audit client after mandatory rotation, whether mandatory rotation would be applied uniformly to all publicly held companies, and how the mandatory rotation process would be implemented for the companies • Excessive overreliance of successor auditors on the work of predecessor auditors Exhibit 2 not to the profession, but . . . to the public at large” (Kapnick, 1974, p. 49). This position rela- tive to accountants can easily be extrapolated to address auditors, as indicated by the following excerpt from testimony on audi- tor independence rules before the SEC: “The SEC’s position is that the auditor ‘owes ultimate allegiance to the corporation’s creditors and stockholders, as well as to the investing public’” (Goodkind, 2000). Second, in the primary sense of the term, the audit firm is not a customer of the audit client: a customer is a “buyer of goods and services” (Zikmund & d’Amico, 1996, p. 104). Howev- er, according to Webster’s New Twentieth Century Dictionary (1977, p. 450), the secondary definition of a customer is some- one “with whom one has to deal”—a definition that certainly indicates the relationship 44 The Journal of Corporate Accounting & Finance / May/June 2006 DOI 10.1002/jcaf © 2006 Wiley Periodicals, Inc. Audit Firm/Audit Client Relationship Issues Audit Firm to Audit Client • Design an organizational policy on potential conflict-of-interest guidelines and review these on a client-by-client basis annually. • Develop an organizational policy against offering of gifts to audit clients. • Review the organizational policy on mandatory rotation of audit partners on client engagements and possibly extend that mandate to senior staff members on an engagement. • Develop an organizational policy as to reliance on predecessor auditor work product when beginning a new client engagement; this policy might contain a list of risk factors to include issues such as the number of predecessor auditor clients that issued restated financial statements in the past five years. • Develop an organizational policy to help evaluate the ethical “tone at the top” in current and potential client companies. • Develop an organizational policy about the aggressiveness that will be accepted in clients’ handling of financial transactions under alternative generally accepted accounting principles. • Perform profitability analyses on clients, being certain to include liability risk levels in such analyses. Such analy- ses should indicate if there are clients that should be “fired” or that merit justifiable increases in audit fees. Audit Client to Audit Firm • Have policies providing potential conflict-of-interest guidelines and have members of management and the board review these annually; conflicts should be addressed by the board audit committee. • Develop organizational policies against acceptance of gifts from audit firms; such policies can typically be drawn from those developed for the purchasing department. • Charge the board audit committee with ascertaining that senior audit firm personnel are not continued beyond a five-year period. • Have the board audit committee analyze the positive and negative aspects of having a mandatory rotation of the organization’s audit firm. • Develop an organizational policy about hiring audit firm personnel for in-house positions; such a policy should begin with communications to the desired employee and then, if appropriate, with audit engagement partners about rotating the individual off the audit engagement. • Have a joint meeting with employees and audit firm personnel at the start of the audit engagement to review and reiterate the whistleblower provisions to employees. • Consider the appropriateness of instituting a compliance officer position to serve as a liaison between the audit firm and the board audit committee. Exhibit 3 between an audit firm and an audit client. Thus, there are similarities of a customer relationship between the entities of audit firm and audit client. In the tra- ditional buyer/seller relationship, the seller wants the buyer to be pleased with the services being rendered so as to retain the buyer for multiple years. In this case, to make the buyer (client company) “pleased,” the seller (audit firm) has to render a clean audit opinion. But, in fact, the audit firm seller is truly in more of an adversarial role to the client buyer—possibly wanting the client buyer to adjust its desires (clean opinion on internally developed finan- cial statements) to conform to the seller’s demands (revisions to those internal- ly developed statements). In the end, neither the buyer nor the seller renders the ultimate judgment as to “service” acceptability: society, which is not even privy to the purchasing contract, makes the final determination of whether audit services were performed properly. Although the buyer/seller relationship between audit firm and client company is seemingly in limbo, it is obvious that these entities have both a monetary (audit fees and engagement costs) and nonmonetary (public trust and legal liability) relation- ship with one another. And, as in all relationships, both parties should act in ways that enhance, rather than damage, the affilia- tion. SOX has established specific details related to what services may not be provided to audit clients. However, no law can address all circumstances that currently exist or that may arise and have not yet been contem- plated. Thus, audit firms and client companies should each develop internal policies about potential conflicts of interest for audit engagements. For example, conflict-of-interest policies might have prevented the follow- ing two instances. In November 2004, American Express Co. dropped Ernst & Young as its auditor, even though E&Y had that client since 1975; during 2004, the SEC was investigating whether E&Y “violated federal auditor-independence rules by entering into a so-called profit- sharing agreement in the 1990s with American Express’s travel service unit” (Weil, 2004a). At the end of December 2004, Best Buy Co. dismissed Ernst & Young (auditor since 1994) because one of Best Buy’s board members “had a personal-service agreement with [the audit firm] during part of the time he served as an independent director” of the company (Carlson, 2004). Audit firms and audit clients should be proactive and have policies in place to guide deci- sions relative to possible con- flicts of interest—not wait for laws to be passed such as the one currently proposed on audit firm sales of tax shelters to clients and client managers. Given the earlier discussion about gifts between Arthur Andersen and individuals work- ing at audit clients, it is impera- tive that audit firms and client companies each develop organi- zational policies related to the acceptance or provision of gifts. The idea of giving gifts general- ly creates a connotation of mutu- al respect or caring; however, there is a possibility that giving gifts may influence, or have the potential to influence, an indi- vidual in a way that could com- promise or appear to compro- mise that individual’s integrity or impartiality. In fact, the ultimate negative perception of gift giv- ing would be that it constitutes commercial bribery or the “offering, giving, receiving, or soliciting” of something of value “to influence a business deci- sion” (Association of Certified Fraud Examiners [ACFE], 1996). Most organizations currently have internal policies that discourage the receipt of gifts by purchas- ing agents from supplier firms. Given this aware- ness by management of the potential for independence problems relative to gifts from suppliers, it is not unrea- sonable to assume that indepen- dence in appearance could be jeopardized if gifts are provided by audit firms to their client companies. It is impossible to know when an offered or accept- ed item will have significant impact to influence a business decision in any particular indi- vidual. Thus, audit firms should have a policy to mitigate this opportunity for influence—and client companies should need only to simply revise any poli- cies against the receipt of influ- encing gifts to include all orga- nizational members who have contact with the audit firm. The provision in SOX that requires communication between the auditors and the audit com- mittee on the financial statement implications of alternative accounting treatments for signif- icant items essentially forces The Journal of Corporate Accounting & Finance / May/June 2006 45 © 2006 Wiley Periodicals, Inc. DOI 10.1002/jcaf Audit firms and audit clients should be proactive and have policies in place to guide decisions relative to possible conflicts of interest… these two parties to come to an agreement on how “aggressive” the client wants to be in han- dling financial matters—and the level of aggression that the audit firm is willing to sign off on rel- ative to those matters. Many of the recent fraud cases have cited instances of what the public would view as aggressive accounting positions relative to revenue recognition, reserve recognition, asset valuation bases, or asset amortization peri- ods. The determination between conservative versus aggressive positions is not a clear-cut one but should be based on the trans- parency of information that results from the use of alternative principles in the current and future periods. The differentiation between conservative and aggressive application of principles should “connote management judgments that are within the range of reasonableness but are on the safe side or on the cutting edge of the range of reasonableness. Any discussions . . . about the aggressiveness or conservatism of accounting principles should address the manner in which a reasonable range is determined and how choices are made and applied within that range” (AICPA, 2000). The SOX prohibition (Sec- tion 206) on audit firm staff moving directly into high-level positions at client companies basically quashes one of the oft- lauded aspects of working for a public accounting firm. This provision recognizes that audit firm alumni bring to their new positions significant knowledge of how the audit engagement is planned and implemented, including details of audit testing that could be used to circumvent the audit process. Consider that Richard Causey, Enron’s chief accounting officer, had been a senior manager with Arthur Andersen prior to his employ- ment at Enron and had primary responsibility for the Enron engagement; additionally, Jeffrey McMahon, Enron’s chief finan- cial officer, was also an Ander- sen alum (Smith, 2002). It is not unreasonable for a client compa- ny to want to hire someone who has intimate knowledge of that organization into an executive officer position, nor is it unrea- sonable for audit staff members who want to leave public accounting to desire to take posi- tions in organizations with which there is familiarity. However, the question of independence in appearance could naturally be raised in the now-prohibited “exchange of personnel” circum- stances. Assuming that the audit firm/audit client relationship is amiable and both parties wish to continue that relationship, a client company should have a policy addressing the potential hiring of audit firm personnel. In many cases, the client may not have an overwhelming immedi- ate need to fill the position and, thus, after ascertaining interest by the employee, client manage- ment should communicate with the audit engagement partners about rotating that individual off the audit engagement. The change in client assignments should be made so as to ensure a smooth transition for the audit team to complete the engage- ment as well as for the desired audit employee to enter the new position at the client company. Such actions are essential to maintaining the integrity of the audit, obtaining the desired employee for the position, and eliminating a forced need to change audit firms (which would have the potential for increased audit risk and audit fees). Two final relationship issues must be considered. First, audit firms must develop an analysis technique that will help them determine which clients to keep and which to “fire.” Over the past ten years or so, businesses have often been told that they need to assess customer prof- itability and, after doing so, eliminate or change the relationships that exist with customers that are unprof- itable. Some audit firms have begun to make the same types of determina- tions and are now trimming their client lists. According to Mark Cheffers, CEO of Audit- Analytics.com, the trend is toward “bigger firms resigning from smaller accounts,” but the Big Four accounting firms do not agree that the partings are always from small companies (O’Sullivan, 2004b). As in all analytical decisions, client analy- sis should include both quantita- tive measures, such as profitabil- ity, and qualitative measures, such as number and type of client disputes over financial statement reporting issues and risk of legal liability related to lack of transparency in client reporting. Second, client companies may want to consider instituting a new chief compliance officer (CCO) position. In some compa- nies, such as The Men’s Wear- house, Inc., the CCO is in charge of the overall SOX effort; in other companies, such as Arrow 46 The Journal of Corporate Accounting & Finance / May/June 2006 DOI 10.1002/jcaf © 2006 Wiley Periodicals, Inc. …audit firms must develop an analysis technique that will help them determine which clients to keep and which to “fire.” [...]... auditor Client relationship and quality of earnings: A case for mandatory auditor rotation The Accounting Review, pp 779–799 Norris, F (2003, December 24) The auditors never noticed New York Times Retrieved December 27, 2003, from http://www.nytimes.com Norris, F (2004) Parmalat sues former auditors New York Times Retrieved December 31, 2004, from http:// www.nytimes.com O’Sullivan, K (2004a, October)... 26) American Express to drop Ernst as auditor next year Wall Street Journal, p C3 Weil, J (2004b, December 23) Fannie’s dismissal of KPMG shows dwindling choices among Big Four Wall Street Journal, p C1 Weymann, E., Raiborn, C., & Schorg, C (2003, December) Creating new psychological contracts in the auditing profession Unpublished paper presented at the Annual Meeting of the American Academy of Accounting... Journal of Accountancy, pp 110–127 Evans, G (2002, March 10) All change please AccountancyAge.com Retrieved March 12, 2002, from http:// www.financialdirector.co.uk George, N (2004, December) Auditor rotation and the quality of audits The CPA Journal, 74(12), 22–27 Goodkind, T S (2000, September 13) Statement of Thomas S Goodkind, CPA, before the Securities and Exchange Commission Retrieved November... (2003, November) Public accounting firms: Required study on the potential effects of mandatory audit firm rotation Report to the Senate Committee on Banking, Housing, and Urban Affairs and the House Committee on Financial Services Retrieved December 23, 2004, from http://www.gao.gov/ atext/d04216.txt Healey, T (2004, March 12) The best safeguard against financial scandal Financial Times Retrieved March... firm rotation For example, in April 2003, Intel’s audit committee indicated that it would consider changing auditors regularly in order to obtain “a fresh look” at its financial accounting and internal controls and would also “consider the advisability and ramifications of a formal rotation policy” (Hill, 2003) Regardless of whether audit firm rotation is ever mandated by law, there will be a natural rotation. .. River, NJ: Prentice Hall/Financial Times Terry, G (2002, September 23) Examining the efficacy of auditor rotation Business Day (Johannesburg) Toffler, B L (2003) Final accounting New York: Broadway Books Webster’s New Twentieth Century Dictionary (1977) New York: Collins World © 2006 Wiley Periodicals, Inc The Journal of Corporate Accounting & Finance / May/June 2006 Weil, J (2004a, November 26) American... firm rotation has its benefits and its drawbacks It could solve some problems but could, in turn, create others However, there is one situation that mandatory audit firm rotation, in and of itself, will never be able to solve: it will not preclude people in either the audit firm or the client company from acting unethically Ethical behavior cannot be mandated; it can only be personally developed—and encouraged... in England & Wales (ICAEW) (2002, July) Mandatory rotation of audit firms Retrieved December 23, 2004, from http://www.icaew.uk/publicassets/00/ 00/03/64/0000036465.pdf Kapnick, H (1974) Accountants—Accountable to whom? In the public interest Chicago: Arthur Andersen & Co Landler, M (2003, December 25) Scandal outrages Europeans; Solutions may be patchwork New York Times Retrieved December 27, 2003,... disaster should additional audit firms merge or become nonviable This problem will be especially perverse for companies operating in a niche business environment Some companies are actually beginning to think that mandatory rotation may be a good idea The GAO report indicated that about 4 percent of the Fortune 1000 public companies and their audit committees are currently considering a policy of mandatory. .. individual [could] use to erase unrelated taxable income” (Bryan-Low, 2004) Although mandatory rotation does not appear to be in the offing in the near future, one possible method to handle it would be to utilize the tradition of law in which lawyers essentially “draw” a judge for a case (Weymann, Raiborn, & Schorg, 2003) Audit firms could be categorized by the Public Company Accounting Oversight Board . maximum number of years prior to mandatory rotation, the number of years before a firm could recompete for an audit client after mandatory rotation, whether mandatory rotation would be applied. reserve recognition, asset valuation bases, or asset amortization peri- ods. The determination between conservative versus aggressive positions is not a clear-cut one but should be based on the trans- parency. billion, Par- malat had been included in the 30 most valuable companies on the Milan Stock Exchange. Deloitte & Touche of Italy served as Parmalat’s primary auditor between 1999 and Janu- ary