roush et al - 2011 - auditor rotation - the pcaob considers a new direction

Current Issues in Auditing American Accounting Association Volume 5, Issue 2 DOI: 10.2308/ciia-50100 2011 Pages C15–C20 COMMENTARY Auditor Rotation: The PCAOB Considers a New Direction Pamela B. Roush, Bryan K. Church, J. Gregory Jenkins, Susan A. McCracken, and Jonathan D. Stanley SUMMARY: The Public Company Accounting Oversight Board (PCAOB) recently undertook an exploration of the need for mandatory audit firm rotation with its issuance of the Concept Release on Auditor Independence and Auditor Rotation (PCAOB 2011a). The accumulation of evidence from PCAOB inspections of audit engagements over the last eight years has led the Board to consider additional steps to protect auditors’ independence. We provide a brief synopsis of these matters based primarily on remarks by the PCAOB’s chairman, James R. Doty (PCAOB 2011b, 2011c). In addition, we include relevant observations from prior academic studies and end with a call for the active participation of stakeholders in this important debate. Keywords: auditor rotation; regulation; inspection. OVERVIEW On August 16, 2011, the Public C ompany Accounting Oversight Board issued PCAOB Release No. 2011-006, titled Concept Release on Aud itor Independence and Auditor Rotation, ‘‘to e xplore whether there are other approaches that could more systematically insulate auditors from the forces that pull them away from the necessary mindset’’ (PCA OB 2011a). We Pamela B. Roush is an Associate Professor at the University of Central Florida, Bryan K. Church is a Professor at Georgia Institute of Technology, J. Gregory Jenkins is a Professor at the Virginia Polytechnic Institute and State University, Susan A. McCracken is an Associate Professor at McMaster University, and Jonathan D. Stanley is an Assistant Professor at Auburn University. The authors are members of the American Accounting Association’s Auditing Section’s PCAOB Synthesis Project Team on Independence. The views expressed in the paper are solely those of the authors and do not represent the views of either the American Accounting Association or the Auditing Section. Submitted: September 2011 Accepted: October 2011 Published Online: December 2011 summarize the PCAOB’s discussion o n this issue, based mainly on statements made by James R. Doty, the recently appointed chairman (PCAOB 2011b). While each of t he members of the PCAOB has made statements regarding audit firm rotation, we focus on Chairman Doty’s rema rks because of his position an d role in establishing the agenda of the PCAOB. We also intersperse observations from academic findings as well as our opinio ns that are pertinent to Chairman Doty’s comments. We encourage others to participate in this extremely important discussion. CHAIRMAN DOTY’S VIEWS At the core of the PCAOB’s oversight responsibility for public company audits is its duty to protect the interests of investors and further the public interest in the preparation of informative, accurate, and independent audit reports. As such, the PCAOB’s mission is to promote an atmosphere that protects audit quality, to reduce the risks of audit failures in the U.S. public securities market, and to promote public trust in both the financial reporting process and the auditing profession. Chairman Doty believes that the current arrangement, where the auditor is paid by the auditee, and long associations exist between auditors and clients, particularly large clients, are issues that must be addressed to fulfill the mission of the PCAOB. Chairman Doty views audit firm rotation as a potential counterweight to the inherent conflict created by the current structural arrangements (PCAOB 2011b, 2011c). Chairman Doty believes that the very size, complexity, and systemic risk found in today’s issuer population supports the need for reconsideration of audit firm rotation at this time. He notes that the PCAOB has seen evidence of ‘‘auditors marketing themselves to potential clients as ‘a partner in supporting and helping’ the client ‘achieve its goals’’’ (PCAOB 2011b). Chairman Doty does acknowledge, however, that improper auditor conduct would be a problem regardless of the auditor’s tenure. In the short term, auditors might please the client to foster a lasting relationship. In the long term, auditors might make concessions to preserve relationships and avoid losing clients. Chairman Doty believes it is worth exploring how audit firm rotation could possibly mitigate these incentives (PCAOB 2011b, 2011c). THE HISTORY OF THE DEBATE Chairman D oty notes that limiting an audit firm’s tenure is not a new idea and has been discussed by various c ommentators and organizations for some time (PCAOB 2011b, 2011c). Past public debate has described the basic arguments both for and against mandatory term limits. In 1977, the Metcalf Repo rt recommended auditor rotation to remedy independence issues created by long associations between corporations and their auditing firms. A year later, the AICPA’s Cohen Commission considered aud itor rotation for independence protection and providing a fresh viewpoint. In its final rep ort, the Cohen Commission rejected auditor rotation, concluding that such an arrangement is not cost beneficial. The question of mandatory rotation surfaced again in 2002 when Congress considered requiring audit firm term limits during the debates that led to the p assage of the Sarbanes-Oxley Act. The U.S. Government Account ability Office (GAO) was charged by Congress to examine issues surrounding auditor ro tation. The final GAO report issued in 2003 rejecte d auditor rotation, but noted that the SEC and the PCAOB would need several year s to evaluate the effectiveness of the Sarbanes- Oxley reforms. That is, the PCAOB would need time to determine w hether the reforms are sufficient, or whether further Auditor Rotation: The PCAOB Considers a New Direction C16 Current Issues in Auditing Volume 5, Issue 2, 2011 independence me asures, such as audit fir m rotation, are necessary to protect investors and enhance auditor independence and audit quality (GAO 2003). PREVIOUS RESEARCH We would like t o note t hat the GAO’s study surveyed public accounting firms with more than 10 audit clients and Fortune 1000 companies. Respondents include 74 public accounting firms, 201 chief financial officers, a nd 191 audit committee chairs. Respondents overwhelmingly opposed mandatory audit firm rotation. A fundamental concern with rotation is that it is unduly costly, and the burden of change may be disproportionately high for small audit firms. DeFond and Lennox (2011) document that a substantial number of small audit firms have ten or fewer clients, with many having just one audit client. The effect of mandatory rotation on such audit firms could be significant. By comparison, an audit failure t hat could have been avoided in a mandatory rotation regime could have a significant negative impact on investors and creditors. Academic research that directly examines the effect of mandatory audit firm rotation is scant because, except for a handful of countries, such a regulatory regime has not been implemented. A notable exception is Ruiz-Barbadillo et al. (2009), who look at auditor reporting behavior in Spain from 1988–1995, a time period during which audit firm rotation was required in Spain. Ruiz-Barbadillo et al. (2009) compare the auditor’s propensity to issue a going-concern opinion across periods with and without audit firm rotation. The study fails to document any significant differences in the auditor’s reporting behavior. While their findings do not provide any evidence to suggest that audit firm rotation improves audit quality, it is important to note that the study examines auditor behavior in a country with different economic and cultural dynamics than those in the United States. Other academic research investigates the effect of audit firm tenure on various proxies for audit quality. Chairman Doty suggests that short tenure may be problematic as audit firms try to build relationships with their clients, and that mandatory rotation likely would be an effective means to curb such behavior (PCAOB 2011b, 2011c). However, we note that a more pressing concern with short tenure may be the auditor’s lack of familiarity with the client. Empirical evidence suggests that audit quality is relatively lower in the initial years of an auditor-client relationship. Specifically, short tenure is positively associated with audit reporting failures (Geiger and Raghunandan 2002), fraudulent financial reporting (Carcello and Nagy 2004), and reduced earnings quality (Johnson et al. 2002). A lack of familiarity may have adverse consequences, which could be exacerbated by instituting mandatory audit firm rotation. Chairman Doty also is concerned with long tenure, suggesting that auditors are incentivized to avoid being ‘‘the engagement partner that lost the client.’’ He offers anecdotal evidence of auditors conceding to client demands where auditor tenure is very lengthy (PCAOB 2011c). Such evidence is certainly disquieting. Yet, academic evidence generally does not suggest that long tenure is detrimental to audit quality (e.g., Johnson et al. 2002; Myers et al. 2003; Carcello and Nagy 2004; Knechel and Vanstraelen 2007); however, for a notable exception refer to Davis et al. (2009). PCAOB INSPECTIONS AND ENFORCEMENT The potential benefits of mandatory rotation are difficult to predict. The PCAOB’s inspections, however, suggest that the current regulatory regime provides ample room for improvement. After Auditor Rotation: The PCAOB Considers a New Direction C17 Current Issues in Auditing Volume 5, Issue 2, 2011 eight years of conducting annual inspections of the largest and smaller domestic and non-U.S. firms, inspectors have found hundreds of audit deficiencies where, in many cases, auditors failed to exercise the required skepticism and accepted less than persuasive evidence. 1 Similar concerns have surfaced in the PCAOB’s enforcement program. The Board’s efforts to address these problems through inspections and enforcement are ongoing. Based on the disturbing lack of skepticism, along with the fundamental importance of independence to the performance of quality audit work, Chairman Doty believes ‘‘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.’’ Chairman Doty states that he does not have ‘‘a predetermined idea as to whether the PCAOB ultimately should adopt term limits. My only predilection is that the PCAOB deepen the analysis of how we can better insulate auditors from client pressure and shift their mindset to protecting the investing public’’ (PCAOB 2011c). It is important to note that the number of audit deficiencies identified in the inspection process has declined markedly over time (PCAOB 2008). Moreover, extant evidence indicates that a relatively small proportion of audit deficiencies results in a misstatement (Hermanson et al. 2007; Church and Shefchik 2012). MOVING FORWARD Chairman Doty acknowledges the considerable implementation challenges associated with mandatory rotation. Therefore, the concept release also pursues the study and consideration of ways to mitigate such challenges. Chairman Doty states that the reason to consider the concept of auditor rotation is to resolve the question to which the discussion of independence, skepticism, and objectivity always seems to return. That is, will term limits reduce the pressures auditors face (PCAOB 2011b)? Chairman Doty challenges both critics and proponents alike ‘‘to do their homework, come forward with facts, and add meaningful depth to the discussion, in order that we might reach resolution.’’ He encourages the discussion to go beyond the conventional wisdom ‘‘which often stops with the assumption that term limits would mean little or no improvements in audits and higher fees.’’ While recognizing a learning curve for new auditors when auditors change, the learning curve and cost-based issues are not ‘‘uncharted waters.’’ Chairman Doty cites recent research by Glass Lewis & Co. which finds that ‘‘between 2003 and 2006, more than 6,500 public companies, or nearly 52 percent of all public companies, voluntarily changed their auditors’’ (PCAOB 2011b). Chairman Doty encourages analysis and consideration of how the auditors, companies, and audit committees involved managed these voluntary changes to ensure that the new auditors were in a position to provide reasonable assurance in the early years of an engagement. 1 In Chairman Doty’s speeches and in the text of the concept release, audit failure is used to describe what we are calling audit deficiencies. It is important to note that the concept release defines audit failure as the following: ‘‘In this context, an audit failure is a failure to obtain reasonable assurance about whether the financial statements are free of material misstatement. That does not mean that the financial statements are, in fact, materially misstated. Rather, it means that the inspection staff has determined that, because of an identified error or omission, the firm failed to f ulfill its fundamental responsibility in the audit—to obtain reasonable assurance about whether the financial statements are free of material misstatement. In other words, investors were relying on an opinion on the financial statements that, when issued, was not supported by sufficient appropriate evidence.’’ Often, audit firms do not agree with a significant number of the deficiencies found by the PCAOB. Auditor Rotation: The PCAOB Considers a New Direction C18 Current Issues in Auditing Volume 5, Issue 2, 2011 We note that, while a large number of auditor changes are documented for the period 2003–2006, the extent to which many of these changes was voluntary is unclear. DeFond and Lennox (2011) find that, over this time period, nearly one-third of small firms with audit clients stopped performing audits altogether. Such unexpected changes in auditors are not necessarily beneficial to audit quality. Blouin et al. (2007) look at what happened to former Arthur Andersen clients, who were forced to change auditors, and do not find any evidence to support improved audit quality, regardless of whether clients followed Andersen personnel to a new auditor. FINAL THOUGHTS Finally, Chairman Doty foresees an active and important role for the PCAOB in supporting a full and informed debate about how to counteract the conflicts that auditors face. Therefore, he expects that the PCAOB will issue several policy documents in the near-term. We applaud the PCAOB’s efforts ‘‘to foster broad debate and research about ways to enhance both the relevance and credibility of audits and to provide the investing public a better understanding of what an audit is through enhanced transparency’’ (PCAOB 2011c). In closing, while the vast majority of academic findings are not supportive of mandatory audit firm rotation (e.g., Cameran et al. 2005; Stefaniak et al. 2009), we do encourage others to participate in this important discussion of auditor independence and to not sit on the sidelines. REFERENCES Blouin, J., B. M. Grein, and B. R. Rountree. 2007. An analysis of forced auditor change: The case of former Arthur Andersen clients. The Accounting Review 82 (3): 621–650. Cameran, M., D. Di Vincenzo, and E. Merlotti. 2005. The Audit Firm Rotation Rule: A Review of the Literature. Working paper, Bocconi University. Carcello, J. V., and A. L. Nagy. 2004. Audit firm tenure and fraudulent financial reporting. Auditing: A Journal of Practice & Theory 23 (2): 55–69. Church, B. K., and L. Shefchik. 2012. PCAOB inspections and large accounting firms. Accounting Horizons 26 (1). Davis, L. R., B. S. Soo, and G. M. Tro mpeter. 2009. Auditor tenure and the ability to meet or beat earnings forecasts. Contemporary Accounting Research 26 (2): 517–548. DeFond, M. L., and C. S. Lennox. 2011. The effects of SOX on small auditor exits and audit quality. Journal of Accounting and Economics 52: 21–40. Geiger, M., and K. Raghunandan. 2002. Auditor tenure and audit reporting failures. Auditing: A Journal of Practice & Theory 21 (1): 67–78. Government Accountability Office (GAO). 2003. Public accounting firms: Required study on the potential effects of mandatory audit firm rotation. Available at: http://www.gao.gov/new.items/d04216.pdf Hermanson, D. R., R. W. Houston, and J. C. Rice. 2007. PCAOB inspections of smaller CPA firms: Initial evidence from inspection reports. Accounting Horizons 21 (June): 137–152. Johnson, V., I. Khurana, and J. Reynolds. 2002. Audit-firm tenure and the quality of financial reports. Contemporary Accounting Research 19 (4): 637–660. Knechel, W. R., and A. Vanstraelen. 2007. The relationship between auditor tenure and audit quality implied by going concern opinions. Auditing: A Journal of Practice & Theory 26 (1): 113–131. Myers, J., L. Myers, and T. Omer. 2003. Exploring the term of the auditor-client relationship and the quality of earnings. The Accounting Review 78 (3): 779–799. Public Company Accounting Oversight Board (PCAOB). 2008. Report on the PCAOB’s 2004, 2005, 2006, and 2007 Inspections of Domestic Annually Inspected Firms. PCAOB Release No. 2008-08. Washington, D.C.: PCAOB. Public Company Accounting Oversight Board (PCAOB). 2011a. Concept Release on Auditor Independence and Audit Firm Rotation. PCAOB Release No. 2011-006. Washington, D.C.: PCAOB. Auditor Rotation: The PCAOB Considers a New Direction C19 Current Issues in Auditing Volume 5, Issue 2, 2011 Public Company Accounting Ov ersight Board (PCAOB) . 2011b. Issuance of a concept release on auditor independence and audit firm rotation. A vailabl e at: http://pcaobus.org/News/S peech/Page s/08162 011_ DotyStatement.aspx Public Company Accounting Oversight Board (PCAOB). 2011c. Rethinking the relevance, credibility and transparency of audits. Available at: http://pcaobus.org/News/Speech/Pages/06022011_DotyKeynoteAddress.aspx Ruiz-Barbadillo, E., N. Gomez-Aguilar, and N. Carrera. 2009. Does mandatory audit firm rotation enhance auditor independence? Evidence from Spain. Auditing: A Journal of Practice & Theory 28 (1): 113–135. Stefaniak, C., J. C. Robertson, and R. W. Houston. 2009. The causes and consequences of auditor switching: A review of the literature. Journal of Accounting Literature 28: 47–121. Auditor Rotation: The PCAOB Considers a New Direction C20 Current Issues in Auditing Volume 5, Issue 2, 2011 Reproduced withpermission ofthe copyrightowner. Furtherreproduction prohibitedwithout permission. . Independence and Auditor Rotation, ‘‘to e xplore whether there are other approaches that could more systematically insulate auditors from the forces that pull them away from the necessary mindset’’ (PCA. defines audit failure as the following: ‘‘In this context, an audit failure is a failure to obtain reasonable assurance about whether the financial statements are free of material misstatement. That. several year s to evaluate the effectiveness of the Sarbanes- Oxley reforms. That is, the PCAOB would need time to determine w hether the reforms are sufficient, or whether further Auditor Rotation: