velte - 2012 - external rotation of the auditor

J Manag Control (2012) 23:81–91 DOI 10.1007/s00187-012-0149-8 ORIGINAL PAPER External rotation of the auditor Patrick Velte Published online: 29 February 2012 © Springer Verlag 2012 Abstract The European Commission (EC) discusses in her regulation draft of 2011 the external mandatory auditor rotation (audit firm rotation) principally after six years as a reform measure to increase auditor independence, which could complement the internal mandatory rotation (auditor rotation) by the 8th EC directive of 2006. First, the present short survey paper contains a theoretical foundation of audit firm rotation, whereby the influences on low balling will be discussed. Furthermore, the paper gives a review of the empirical auditor change research. In contrast to the perception of the EC, the empirical results mainly don’t state an increased financial accounting and audit quality by an external rotation of the auditor. Keywords Empirical auditor change research ·Low balling · Audit quality · Earnings management 1 Introduction Facing the capital markets’ shrinking trust in the decision usefulness of financial accounting and auditing as a result of the financial crisis, the European Commission (EC) in a current regulation draft (EC 2011) is in quest of ways to reform the profes- sional standards of accountants and auditors. The intention of the EC is to enhance audit quality by reducing the expectation gap (Liggio 1974), increasing auditor independence and preventing further audit market concentration (Velte and Sepetauz 2012, 9). In order to better auditor independence, based on independence in fact as well as on independence in appearance, the EC is considering introducing mandatory external rotation (audit firm rotation) principally after six years and with regard to a P. Velte (  ) School of Business, Economics and Social Sciences, Department of Business Administration, University of Hamburg, Max-Brauer-Allee 60, 22765 Hamburg, Germany e-mail: Patrick.Velte@wiso.uni-hamburg.de 82 P. Velte cooling off period of four years. While internal rotation (auditor rotation) stipulates changes within the audit firm, external rotation replaces the audit firm entirely, following a fresh start approach (Weber 2005, 880). Currently Italy is the only state in the EU with audit firm rotation rules (since 1974). Austria introduced external rotation for financial years beginning on January 1, 2004, but repealed it before it came into effect (Doralt 2008, 419). Similarly, compulsory audit firm rotation no longer exists in Greece and Spain. Upon passage of the modified 8th EC directive (EC 2006), audit firm rotation was not codified due to, according to the EC’s assessment then, negative effects on audit quality were expected. For auditing bodies of public interest firms, compulsory internal rotation was introduced as a substitute aiming to enhance auditor independence. Based on the 8th EC directive, all responsible partners of auditing companies are ob- ligated to submit to an internal rotation no later than after seven years. After a cooling off period of two years, the auditor in charge may reapprove his audit services with a given client. Now, the EC discusses a one year increase of the cooling off period of the internal rotation. Consistent with the EC’s opinion of that time, the Sarbanes Oxley Act (2002) introduced an internal rotation cycle of five years as well as a cooling off period of two years for all auditors who are primarily responsible for the mandate at hand or in charge of an internal revision of audits, and provided audits for clients in question (Schmidt 2003, 785). For all non-responsible auditors in charge of crucial cases who are in regular contact with the company’s administration, an extended rotation period of seven years, followed by a cooling off period of only one year is to be observed. In light of the recent explosiveness caused by the EC regulation draft as well as various forms of rotation from an international point of view, this short review paper contains an agency theoretical foundation (low balling) and an analysis of the empirical audit research regarding effects of audit firm rotation on financial accounting- and audit quality. With the EC reform lacking a theoretical basis of the subject as well as an inventory of empirical research on auditor change, the EC’s assumption of a positive link between rotation and quality of financial accounting and auditing is to be discussed. The analysis is structured as follows: Sect. 2 includes an agency theoretical foundation of external rotation with special consideration of low balling (Sect. 2.1) and a review of the main positive and negative effects of external rotation on audit quality Sects. 2.2, 2.3). Subsequently, recent results of empirical auditor change research will be discussed in Sect. 3, whereby the results differ between increased (Sect. 3.1) and decreased accounting/audit quality or lack of proof (Sect. 3.2). Section 4 summarizes the results. 2 Agency theoretical foundation 2.1 Basic low balling model of DeAngelo (1981a) and modifications Several theoretical approaches focus on the correlation of the board of directors (one tier system) or the management- and supervisory board (two tier system) and their special relationship to the external auditor. This paper will dwell on the double-level External rotation of the auditor 83 principal agent theory according to Tirole (1986), which is most important in international auditing research (Freidank et al. 2009; Velte and Weber 2011). The auditor acts as an “double agent” of the board and the shareholders. The relation between auditor and shareholder is hereby summarized in the gatekeeper function. Furthermore, an assisting role of the auditor results from his support for the audit committee with regard to the internal supervising of the management. The traditional agency models do not provide for periodic or obligatory auditor changes, with extreme cases allowing for indefinite mandates (Ewert 2003, 535). The famous low balling model of DeAngelo (1981a, 113) and its modifications are often mentioned in auditor change literature. The risks of an asymmetrical distribution of information in audits can be magnified through the low balling phenomenon. The low balling effect, where the audit fees for the initial mandate as negotiated with the client will not cover the actual costs, may have an impact on the auditor independence and provide an incentive to form coalitions to the detriment of the public (DeAngelo 1981a, 113). According to DeAngelo’s basic model (1981a, 113), the initial audit will cause start up costs because the auditor will have to first familiarize himself with the business activities and environment of the company. Empirical evidence for such familiarization costs was given, among others, by Ridyard and DeBolle (1992). Still, agencies choose a low balling strategy for reasons of crowding out competitors, qualifying the initial losses of the first audit as a market entry barrier for competing auditors. Learning effects in follow up audits, which reduce audit costs, were found empirically by Rubin (1988) and Roberts and Glezen (1990), among others. These information and cost advantages are an additional market entry barrier for competitor auditors in later audit periods (Quick 2002, 628). The continuous increase in remuneration (fee cutting) through strategic market considerations has a positive effect on quasi rents and strengthens the low balling strategy. A lack of fee cutting, however, does not necessarily mean that a low balling strategy was not utilized. Reversely, the presence of fee cutting is not necessarily evidence of a low balling strategy. At first, fee cutting could not empirically be shown, cf. Ettredge Palmrose (1982, 1986), Rubin (1985), Simunic (1980). Only since the late 1980s empirical evidence has increased, see Ettredge and Greenberg (1990), Turpen (1990), Gregory and Collier (1996) and Craswell and Francis (1999). More recently, the fee cutting strategy has become less attractive for audit companies because mandatory declarations in the notes and in the transparency report of the audit company have made it easier for the capital market to identify fee cutting. Empiri- cal measuring of the low balling process, on the other hand, is much more difficult, since the individual self costs of audit firms in the initial audit are not reconstructible for clients (Simons 2011, 162). Marten (1994) had assumed a low balling tendency on the basis of a survey among German auditors. Schatzberg (1990), Schatzberg and Sevcik (1994) and Schatzberg et al. (1996) had found evidence of low balling through experiments, only. DeAngelo’s (1981a, 113) basic model only focuses on audit services. Beck et al. (1988) extend the low balling model by consulting services. Continuous consulting services will experience a low balling effect on the combined offer of audit and consulting. Taking into account the spill overs between audit and consulting services, the absolute economic advantage of the auditor is greater than if he limited his services 84 P. Velte to audits if the sum of training costs for the consultant and the consulting costs are greater than the cost reduction through auditor training by means of knowledge trans- fer. Insofar a combined supply of audit and non audit services enhance the motivation for low balling and have an negative impact on auditor independence. A further modification of the basic low balling model was submitted by Magee and Tseng (1990), who add differences of opinion between client and auditor. Differences of opinion originate in a conflict about (non-)acceptance of a certain questionable accounting policy. The economic advantage of maintaining the auditing assignment due to positive transaction costs of the change is only incurring a restriction of independence if differences of opinion are of multi periodical nature, various types in the auditing industry regarding evaluation of accounting, the client is unable to distinguish the type of the auditor, and the auditor himself knows his type only after the election. Conflicts between management and auditor have an essential impact on low balling and the quasi rents, because the management likes to assign an auditor, who doesn’t submit a modified opinion (opinion shopping; Velte 2010). Finally, Lee and Gu (1998) have established in their case that auditor independence is strengthened by low balling if the auditor receives his assignment directly from the shareholders. In such a case, quasi rents have the effect of a security deposit which is immediately withdrawn if malperformance occurs. Although in a stock corporation, from a German point of view, the auditor is elected by the stockholders, the assignment is awarded by the supervisory board as a representative of the general assembly. Following Lee and Gu (1998), an accordingly positive effect of low balling only occurs if the supervisory board acts on behalf of the shareholders at all times, is independent from the management, and possesses appropriate financial ex- pertise. A long-term assignment is equally necessary in order to extend quasi rents, upon which a re-election of the auditor is to be expected. From a German point of view there is normative restriction based on the auditor’s internal rotation cycle and the necessity of annual re-election. The proposal contained in the EC green paper of 2010 (EC 2010), suggesting the responsibility of assignments to be transferred to an independent regulatory entity aims at the prevention of low balling which is be related to setting a minimum audit fee and introducing a schedule of fees. But this reform measure is not subject to the EC regulation draft of 2011 any longer. 2.2 Increased auditor independence by external rotation External auditor rotation is often considered a way to enhance audit quality due to prevention of the auditor’s depending relationship with the management, distinguish- ing between the auditing of capital market oriented and non-capital market oriented corporations. Since traditional agency conflicts are characteristic in large management operated corporations, the necessity of a statutory rotation is solely related to this group of companies. Shareholders in small and medium-size companies are to exert greater influence on the management than an average private shareholder in a public company. This dichotomy in auditing standards has recently been contem- plated by the EC. Based on the legal approach in Switzerland (Kavan and Mueßig 2011), “short cut” audit with low level scrutiny is being considered for small and medium-size companies, in order to grant financial relief to the small firm sector. External rotation of the auditor 85 Burton and Roberts (1967) present a fundamental approach to the economic impact of auditor changes. Although, considering the assistant role of an auditor in a stock corporation, a long-term contract between supervisory board and auditor seems sensible, the independence in appearance might be limited due to a special trust relationship between management and auditor in a long-term assignment. Burton and Roberts (1967) suggest that personal relationships between auditor and management, the combination of auditing and consulting, as well as the auditor’s goal of maintaining the assignment are determining factors towards reducing audit quality. According to DeAngelo (1981a, 113), quasi-rents according to low balling without compulsory rotation might present a financial incentive to the auditor to give up his independence, if the probability of exposure by the capital market is considered to be low. According to supporters of this theory, an auditor’s low balling strategy which might be related to his lack of independence can be counteracted by compulsory rotation (Ewert 2003, 536). In opposite, Chi et al. (2004) state an adverse rotation effect on auditor independence if the owners assign the auditor. The quasi rents can be classified as a “pledge” according to Lee and Gu (1998). They point out that auditor independence is decreased in the last audit period before the rotation by hidden transfers of the management. The auditor is not concerned any longer about the potential loss of quasi rents due to the non re-election by the shareholders. According to Bigus and Zimmermann (2007), the absolute (client related), but not necessarily the relative quasi rents are cut short due to rotation, which implies that rotation does not necessarily cause an increase of auditor independence. Irreconcilable differences of opinion between management and auditor are not risky to the auditor if a change is scheduled for the near future anyway, which is mentioned as another possible advantage. Literature assumes stricter and more re- lentless auditing under compulsory rotation, considering that the auditor wishes to diminish the risk of having his successor complain about his low performing upon review of previous years’ audits (Ewert 2003, 536). Finally the avoidance of orga- nizational blindness (Leffson 1988, 115) under compulsory rotation is pointed out, as positively influencing the audit efficiency. Hence, the auditor simply trusts his results from previous years instead of anticipating important changes in the company development and adjusting his auditing strategy. 2.3 Increased auditing costs and effects on audit market concentration by external rotation The positive overall effects of compulsory rotation on the limitation and avoidance of low balling as mentioned in literature are not secured, since compulsory rotation creates system immanent disadvantages (Ewert 2003, 536). Thus, a change of the audit form incurs a higher monetary value of auditing costs and increased audit fees which result in additional costs of the initial audit and transaction costs on the part of the client (Herzig and Watrin 1995, 795). Especially long-term audit scheduling and following up on complaints or auditors’ suggestions from previous audit periods would have to suffer under rotation (Luik 1976, 239). Empirical surveys in the US show that the auditor’s risk of liability is significantly higher in first or second audits than in following audits (AICPA 1992). Since first audits tend to be of lower quality, 86 P. Velte negative responses of the capital market are to be expected upon a forced change of auditor. This way an investor can no longer distinguish a voluntary change of auditor due to opinion shopping of the management from a compulsory rotation, which increases his cost of information (Bigus and Zimmermann 2007, 19). Therefore, for corporations which, according to Spence (1973), aim to offer high audit quality to the capital market, compulsory rotation in short intervals may be unfavorable. Even a statutory long-term rotation cycle (e.g. more than nine years) cannot prevent essential agency conflicts, e.g. the risk of hidden intention of management. Audit market concentration is another important disadvantage of compulsory rotation, which the EC critically reviews in the current regulation draft. The European audit market for listed companies is dominated by the Big Four audit firms (Frei- dank and Velte 2012; Velte 2011) and this supplier concentration is enforced by low balling. The reason for this concentration lies in the Big Four companies having the highest experience value in auditing capital market oriented enterprises. According to DeAngelo (1981b, 183) these audit firms tend to a higher quality and independence and have an extensive potential of resources in additional performances such as advisory services to show. This development of oligopoly in the global audit market makes an entry into the market very difficult for small and medium-size audit firms. In general, these difficulties cannot be overcome by compulsory rotation, since changes are made only between Big Four audit companies. Insofar, the EC would have to introduce an obligation to assign a Non Big Four company after the external rotation. But this huge audit market intervention is not acceptable. Furthermore, practical experience suggests frequent changes from small to larger audit companies (Quick 2004, 490). In general view, the impacts under external rotation are stronger than for internal auditor rotation. The overall impact of compulsory rotation is, from a theoretical point of view, uncertain. Even under low balling, the external rotation does not necessarily imply higher quality. The interruption or shortfall of learning and experience effects can have an negative effect on accounting and audit quality. 3 External rotation studies Empirical auditor change research has become highly significant particularly in juris- dictions of the US, Asia, and Australia. In order to determine the quality of financial accounting and auditing, a number of variables are used, which if viewed separately, provide an assessment of limited informational value (Bedard et al. 2008). In general, earnings management is operated by means of discretionary accruals, according to paradigms outlined by Jones (1991) and DeFond and Park (2001). Audit quality is determined by diverging variables, e.g. based on restricted going concern opinions. Facing companies with substantial liquidity issues, an independent auditor tends to restrict or deny the going concern opinion. 3.1 Supporting results to enhanced accounting and audit quality The majority of empirical assessments disapprove of audit firm rotation, since there are either no effects or even negative effects on the quality of accounting and auditing External rotation of the auditor 87 detectable. Only Dopuch et al. (2001), Davis et al. (2009) and Boone et al. (2008) point out positive effects. Dopuch et al. (2001) state based on an experimental study in the US, that in case of audit without external rotation it is more likely that the auditor over time biases approval testates accommodating the management, and conceals errors from the public. In the experiment at hand, however, experience effects of the auditor under a long-term assignment remain uncovered. Davis et al. (2009)show by 12,892 US corporations in the business years of 1991–1998 that the management takes advantage of its leeway in decisions and arrangements in short (two to three years) and very long duration of assignment (at least thirteen years) in order to fulfill or outdo result prognoses. The latter is considered positive by the capital market and may reflect in a higher demand of shares. The authors state that the duration of the audit assignment has a positive effect on the extent of maximum earnings management, so that the audit quality is increased by external rotation after a longer duration. Boone et al. (2008) point out signs of interdependence between external auditor rotation and risk margin on allocated capital contribution in 12,493 surveys on the US capital market during the business years of 1974–2001. Capital costs decrease in the first years of the assignment and rise with its duration. 3.2 Rejecting results to enhanced accounting and audit quality As outlined above, the majority of recent studies either does not show proof or doc- uments a tendency of weakening the quality of accounting and auditing due to external rotation. Johnson et al. (2002) saw comparatively short assignments (two to three years) causing higher training costs combined with a lower quality of accounting in 11,148 US surveys during the business years of 1986–1995, while they did not find proof of lower quality in long-term assignments (at least nine years). Myers et al. (2003) who surveyed 42,302 US corporations between 1988 and 2000 report that auditors in long-term assignments (more than five years) tend to refuse a maximiz- ing earnings management. The auditor has a better knowledge about the management strategy due to learning and experience effects. Likewise, Al-Thuneibat et al. (2011) state a negative correlation between external rotation and the quality of accounting in 358 Jordan companies listed at the stock exchange between 2002 and 2006. In their survey of 35,826 or, respectively, 38,794 US corporations between 1990 and 2000, Ghosh and Moon (2005) show that investors, rating agencies and analysts assume positive interdependence between the duration of assignment and the quality of accounting, represented by the interest rate investors require, rating results, as well as the analysts’ performance prognoses. Contrary to their results with US students on internal rotation, Gates et al. (2007) show that investors’ confidence in the financial accounting quality in a regulatory environment with increased corporate governance methods cannot be influenced by external auditor rotation. Furthermore, according to Carcello and Nagy (2004) based on the business years of 1990–2001, 267 US corporations showed balance manipulations mostly in the first three years of the assignment, since the management assumes lower quality of audit provided by new auditors. A long-term assignment (at least nine years), however, does not imply a significant increase of balance manipulations. Mansietal.(2004), based on 8,529 US surveys between 1974 and 1998, question the usefulness of audit firm rotation and state negative capital market responses in 88 P. Velte the assessment of market-noted stocks of risk intensive companies. Therefore, with greater entrepreneurial risk, investors tend to rate the auditor’s learning and experience effects in a long-term audit assignment higher than possible limitations of his independence. Likewise, Knechel and Vanstraelen (2007) show based on 618 Belgian companies for the business years of 1992–1996 that independence in appearance of the capital market does not decrease with extended assignments. Azizkhani et al. (2007) see the duration of assignment in 2,033 Australian companies between 1995 and 2005 which are audited by Non-Big-Four audit firms in an inverse relation to the size of capital costs, whereas there are no significant changes under external rotation. Fargher et al. (2008) compare the impact of internal and external rotation on 590 Australian companies during the business years of 1990–2004. They show that in the first years after a change of auditor the management lowers the extent of accounting policy if internal rotation has taken place. Under external rotation, however, a significant increase of discretionary periodical classification is established. In relation to the quality of auditing, Geiger and Raghunandan (2002) survey 117 US corporations with significant liquidity issues between 1996 and 1998 and observe the probability of restrictions in going concern opinions to be lower in the first years of the assignment based on a higher reporting error rate of the auditor, based on sanctions by the Stock Exchange Commission (SEC). Jackson et al. (2008) point out, based on 1,750 companies in the Australian capital market between 1995 and 2003 that the probability of restricted going concern opinions increases with the duration of assignments due to the auditor’s experience. According to Jackson et al. (2008), interdependence between the duration of assignment and the quality of financial accounting cannot be established, so that the necessity of compulsory external rotation is ultimately dismissed. In the case of the Spanish audit market, based on 1,326 companies with significant liquidity issues in the business years of 1991–2000, Ruiz-Barbadillo et al. (2009) are not able to state empirically that an external auditor change increases the probability of restricted going concern opinions. 4 Summary Auditor independence is an indispensable requirement in providing appropriate quality of financial accounting and auditing. In order to strengthen auditor independence, the application of external auditor rotation is discussed. While in 8th EC directive of 2006 internal rotation has been mandatory, the EC regulation draft of 2011 raises questions on the necessity of a compulsory external rotation principally after six years, which stipulates the change of the audit firm. Since the EC provides neither a theoretically nor an empirically founded economic justification for the reforms in question, the effect of external rotation on the quality of financial accounting and audit is uncertain. Due to this, the purpose of this analysis is to consult the low balling theory as well as recent results of empirical audit research and critically challenge the EC’s plans. An overview shows that an enhancement of auditor independence will not necessarily be achieved by implementing external rotation. It might be paid for by an interruption or lack of learning and experience. Even under application of External rotation of the auditor 89 low balling, the total effect of rotation on the quality of financial accounting and auditing may be negative. Empirical studies mainly do not show an increased quality of financial accounting and audit under changes of audit firms. Regarding the empirical surveys mentioned above, it has to be pointed out that the focus of empirical auditor change research is mainly on US, Asian, and Australian capital markets, while only a few surveys exist on EU member states such as Belgium and Spain. Furthermore, the variables used to estimate quality of financial accounting and audit, such as discretionary accruals or restriction of going concern opinions, are of limited conclusional value. Based on these facts there is need for action on the part of the EC to perform cross-national empirical studies before implementing compulsory external rotation throughout the EU. Furthermore, external rotation is connected with other reform measures. The proposal of a multi-periodical assignment of auditors as a legitimate temporary auditing monopoly (Mueller and Suttner 2011, 12), such as in Belgium, France, Italy or Spain, is also mentioned in the EC regulation draft and can have an impact on auditor independence in Europe. 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Control (2012) 23:81–91 DOI 10.1007/s0018 7-0 1 2-0 14 9-8 ORIGINAL PAPER External rotation of the auditor Patrick Velte Published online: 29 February 2012 © Springer Verlag 2012 Abstract The European. system) or the management- and supervisory board (two tier system) and their special relationship to the external auditor. This paper will dwell on the double-level External rotation of the auditor. or lack of learning and experience. Even under application of External rotation of the auditor 89 low balling, the total effect of rotation on the quality of financial accounting and auditing