The International Debate Over Mandatory Auditor Rotation: A Conceptual Research Framework Anthony H. Catanach Jr. Paul L. Walker This paper contributes to the recent international debate over mandatory auditor rotation by providing a conceptual research framework in which to view the tenure-audit quality relation. Audit quality is viewed to be a function of auditor performance. The auditor’s ability and professional conduct are argued to be major factors affecting performance. Economic incentives and market structure have endogenous relationships with both performance and tenure. Research implications of the framework suggest that evaluating the efficacy of mandatory auditor rotation is likely to be a complex process, more involved than a simple association test of the tenure-audit quality relation. The study also proposes several avenues for future examination: (1) evaluation of assumptions implicit in rotation arguments; (2) testing of magnitudes and effect directions; (3) examination of professional oversight con- trols; and (4) assessment of the costs of compulsory rotation. © 1999 Elsevier Science Inc. All rights reserved. Key Words: Mandatory Auditor Rotation; Tenure; Audit Quality INTRODUCTION Accountants and academics have debated the need for mandatory audit firm rotation for decades. Israel, Italy, and Spain are among the few countries that have adopted mandatory rotation policies. Canada considered the idea for years and critics of the accounting profession in Australia, Germany, and the United Kingdom recently proposed rotation as a solution to independence concerns in those countries. The American Institute of Certified Public Accountants (AICPA) Anthony H. Catanach Jr. ● Villanova University, College of Commerce & Finance, 800 Lancaster Avenue, Villanova, PA 19085–1678; Phone: 610–519–4825; Fax 610–519–5204; E-mail: acatanach@msn.com. Paul L. Walker ● University of Virginia, McIntire School of Commerce, Monroe Hall, Charlottesville, VA 22903–2493. Journal of International Accounting, Auditing & Taxation, 8(1):43–66 ISSN: 1061-9518 Copyright © 1999 by Elsevier Science Inc. All rights of reproduction in any form reserved. attempted to dispel criticism of the profession in the United States (U.S.) by issuing a Statement of Position on Mandatory Audit Firm Rotation in 1992. In 1994, the U.S. Securities and Exchange Commission (SEC) also considered the issue in its report draft on auditor independence, and the U.S. Senate subsequently drafted legislation requiring auditor rotation for all telecommunication compa- nies. 1 The recent formation of the Independence Standards Board also supports a need for analysis of regulatory actions that promote auditor independence. 2 Despite continued professional debate, little research exists to support either the adoption or rejection of mandatory rotation. This paper reviews the compulsory rotation issues raised internationally, summarizes the existing research evidence on this controversial topic, and proposes a conceptual framework to guide future examinations of the tenure- audit quality relation. By identifying and organizing the major constructs associated with the rotation issue, this framework provides a foundation for the future development of more formalized logical or mathematical models to yield testable research hypotheses. The proposed framework suggests that endogeneity among many of the constructs adds complexity to the tenure- audit quality relation, particularly when national and cultural differences are considered. THE CONTROVERSY SURROUNDING MANDATORY AUDIT ROTATION Arguments for Compulsory Rotation Over the years major organizational collapses have been attributed to poor audit quality associated with a perceived lack of auditor independence. These alleged “audit failures” were deemed to have occurred because auditors failed to either detect or report material errors in the financial statements. Mandatory auditor rotation (compulsory rotation) frequently has been sug- gested as a means of strengthening independence and reducing the incidence of audit failure. 3 Proponents of mandatory rotation argue that it will prevent long-term auditor-client relationships from developing that could impair independence and objectivity. In fact, several studies suggest that longer auditor tenure leads to audit quality decline (DeAngelo, 1981b, 189; Deis & Giroux, 1992, 470; O’Keefe et al., 1994, 53; Raghunathan et al., 1994, 33). Rotation advocates propose that it would reduce audit failures, force clients to adopt conservative accounting practices, and result in more complete financial statement disclosures (OCA, 1994, 53). Rotation also would ensure that a company’s representations, particularly those in subjec- tive and judgmental areas (e.g., intangibles), would be reviewed by different audit “experts.” If the tenure period were limited, auditors also would have greater incentives to resist management pressures (AICPA, 1992, 1–2). Finally, support- 44 INTERNATIONAL ACCOUNTING, AUDITING & TAXATION, 8(1) 1999 ers of rotation suggest that it would foster a more competitive market. However, to date the evidence is mixed on this issue. 4 Arguments Against Mandatory Rotation Opponents of compulsory rotation generally acknowledge the potential ben- efits of its adoption, but argue that implementation costs (both to the auditor and client) greatly exceed the limited gains perceived (AICPA, 1992, 2). The Cohen Commission (1978) indicated that duplication of start-up costs, including the time auditors spend gaining familiarity with the client company, would increase auditor costs considerably. 5 Lost audit efficiencies also may increase costs. Arrunada and Paz-Ares assert that predecessor auditors will not be able to transfer their knowl- edge of the client, its accounting system, and market to successors, and this “value is destroyed by rotation” (European Accountant, 1995b, 7). Additionally, Euro- pean professionals note that rotation may reduce auditor incentives to invest in specific industries (European Accountant, 1995b, 7; Petty & Cuganesan, 1996, 41). If auditors must periodically abandon an industry that requires special knowledge, they may be less willing to specialize in it. The accounting profession argues that mandatory rotation denies auditors the ability to assess the true financial situation of a company because their under- standing of the client’s business, operations, and systems would be limited to only a few years (European Accountant, 1995a, 4). This view is supported by a recent AICPA study that found audit failures occurring more frequently when auditors were performing their first or second audit of a company (AICPA, 1992). 6 Clients also may face increased costs if compulsory auditor change is required. Management faces the potentially disruptive, time-consuming, and expensive process of selecting new auditors, and familiarizing them with the organization’s operations, procedures, systems, and industry (AICPA, 1992, 3). Increased auditor costs also might lead to reduced competition and higher client audit fees (European Accountant, 1995b, 7). However, according to the Cohen Commission, mandatory rotation also could result in “excessive competition” because clients would have difficulty evaluating audit quality differences across firms. This heightened competition might lower audit prices and create pressures that increase the likelihood of faulty audit work. In addition, clients might be forced to accept a lower quality of service from an auditor who is a generalist, if fewer auditors invest in specialized industries (Petty & Cuganesan, 1996, 41). Finally, accounting professionals believe that several key factors in the auditing industry make mandatory rotation unnecessary. The AICPA (1992, 5) suggests that auditors are motivated to maintain objectivity and independence by their desire to protect their reputation and client revenues. Professional behavior is further assured by quality control standards (e.g., peer review programs and periodic partner rotation) implemented by accounting and auditing organizations internationally. Accounting organizations also note that external market forces (e.g., litigation costs and negative publicity) provide controls on auditor behavior. 45The International Debate Over Mandatory Auditor Rotation THE INTERNATIONAL DEBATE AND EXPERIENCE Countries with Active Compulsory Rotation Discussions While most professional accounting organizations have been reluctant to accept compulsory rotation, active debates on the issue continue in at least four countries: Australia, Germany, the United Kingdom (U.K.), and the United States. 7 Research into recent audit failures in Australia finds a lack of independence as a major contributing factor (Walker, 1991, 82). Responding to problem audits witnessed during the 1980’s, the Ministerial Council for Corporations appointed a working party in 1993 to review auditor regulation. While fixed appointment terms were recognized to have some merit, the accounting profession did not support auditor rotation. 8 Not surprisingly, the working party recommended that “the law not impose fixed terms of appoint- ment for auditors or otherwise mandate the rotation of auditors” (Common- wealth Government, 1996, 87). The auditor rotation question is not new to Germany, but the current debate marks the first time that the issue has been discussed so widely. The near collapse of the Metallgesellschaft group in 1994 due to dubious oil derivatives contracts has renewed interest in the topic. In the past few years, the president of the German Shareholders’ Association has called for the mandatory rotation of auditors every five years (Corporate Accounting International, 1994; European Accountant, 1995a, 4). As in many countries, the German accounting profession is universally opposed to rotation. However, Germany’s central bank, the Bundes- bank, recently introduced auditor rotation to encourage German companies to consider the idea (European Accountant, 1996b, 4). 9 During the 1980’s several high profile episodes occurred in the U.K. that suggested deficient auditing practices: DeLorean, Johnson Matthey, Milbury, Westminster Property, Lloyd’s, and Alexander Howden. In response, the government proposed reforms (the EC Eighth Directive) that would curtail non-audit services by auditors and require rotation. However, lobbying by the accounting profession and its corporate clients succeeded in postponing gov- ernmental intervention. Auditing practices again came under scrutiny in the early 1990’s in such cases as Polly Peck, Maxwell, BCCI, and Levitt. 10 This time, the profession commissioned two investigations (the Cadbury Commit- tee and the McFarlane Report) to investigate the role of auditing in these scandals and the need for self-regulation. While the Cadbury Committee opposed the rotation of auditors, the McFarlane report suggested that auditors be appointed for a fixed five year term. During the last twenty years, the U.S. Congress has held extensive hearings on the public responsibilities of the accounting profession and its ability to regulate itself (Leibman & Kelly, 1992, 362). During the 1970’s, outside auditors failed to detect criminal activity among several large U.S. corporations. As a 46 INTERNATIONAL ACCOUNTING, AUDITING & TAXATION, 8(1) 1999 result, the Moss-Metcalf inquiries examined the profession’s ability to detect management fraud and its effectiveness in disclosing bribes to foreign officials (Previts & Merino, 1979, 318). The Metcalf Committee staff report concluded that insufficient independence between auditors and their clients may have contributed to these conditions, and suggested rotation as a solution to the auditor indepen- dence problem. 11 However, in 1978 the Cohen Commission, an independent commission established by the AICPA, concluded that rotation should not be required because its potential benefits would be offset by associated costs (Cohen Commission, 1978, 108). Audit failures stemming from the bank and thrift crises of the 1980’s reignited discussion of the effectiveness of the U.S. accounting profession’s self-regulation program. The Dingell Committee specifically investigated the potential conflict of interest inherent in the auditor-client relationship. The ac- counting profession responded by implementing several organizational changes to promote self-regulation including the adoption of a peer review program. Nev- ertheless, critics of the profession continued to call for mandatory auditor rotation, standardization of fees, and other constraints on the auditor-client relationship (Chatov, 1985, 173). In 1991, the U.S. Comptroller General discussed with Big Six audit firms the possibility of requiring banks to change their auditors on a periodic basis (World Accounting Report, 1991, 257). In 1993, Walter Schuetze, then Chief Accountant of the SEC, proposed mandatory auditor rotation as a solution to the accounting profession’s inability to self regulate (Craig, 1993, 18). Despite continued SEC interest in the independence issue, neither the SEC nor the AICPA, has endorsed the idea of audit firm rotation. 12 International Experience with Mandatory Rotation Italy currently requires the mandatory rotation of external auditors on listed companies, insurers, investment houses, newspaper publishers, state-owned busi- nesses, and companies benefiting from state aid. These companies can keep the same auditor for a maximum of three, three-year terms (or nine total years). The Italian securities regulatory agency, Consob, also has the authority to approve the selection of auditors and to set fees. Consob’s oversight may minimize any excess competition (e.g., fee cutting) caused by rotation, that could result in fewer audit procedures and lower audit quality (OCA, 1994, 54). Although continuing cor- porate scandals in Italy suggest the ineffectiveness of compulsory rotation, its “true” effects remain unknown. 13 Israel adopted audit rotation on “government companies” in the early 1970’s in response to calls by smaller accounting firms for more work. While these firms are required to change auditors every three years, the requirement appears to be loosely enforced. Recently, management of the Electricity Corporation, one of the largest and most profitable companies in Israel, successfully postponed a change in auditors indefinitely (World Accounting Report, 1996, 20). 47The International Debate Over Mandatory Auditor Rotation Prior to 1996, the Spanish government required companies to change audi- tors every three, six or nine years with the total tenure period limited to a maximum of nine years (European Accountant, 1995b, 7). Unlike other countries, Spain apparently did not adopt rotation in response to concerns over auditor independence. Instead, rotation was implemented to allow local firms to gain market share (European Accountant, 1996a, 9). Spain recently has abandoned mandatory rotation and some have considered its decision to be evidence that rotation is not needed elsewhere. 14 In summary, auditor rotation generally appears motivated by public concerns over large, high-profile corporate collapses. As companies fail, auditors are criticized for their performance and perceived lack of independence, and calls originate for regulation of the accounting profession. As evidenced in Spain, mandatory rotation also may increase competition in the audit market. DEVELOPMENT OF A FRAMEWORK Despite the historical controversy over compulsory rotation, little analytical or empirical research exists to either support or reject its adoption. 15 In fact, the AICPA (1992, 2) states “there is no empirical evidence to support the perceived benefit of mandatory audit firm rotation.” Moreover, the potential impact of national and cultural differences on mandatory rotation also has been ignored. Proponents of rotation argue that long-term client relationships lead to lower audit quality and, ultimately, audit failure. To support their position, they point to empirical studies of the tenure-audit quality connection. To date, the preponderance of empirical evidence reveals a negative association between tenure and audit quality. Using audit engage- ment hours as a proxy for audit quality, Palmrose (1989, 496) finds that quality declines with firm tenure. Copley and Doucet (1993, 32) report that the likelihood of a substandard audit increases with the length of auditor tenure. O’Keefe et al. (1994, 52) show initial engagements to be associated with fewer violations of generally accepted accounting standards than repeat engagements. Raghunathan et al. (1994, 33) reveal that audit failures are more likely to occur in the first year or after the fifth year, further suggesting a tenure-audit quality relation. In their examination of law- suits filed against auditors, St. Pierre and Anderson (1984, 249) reveal that only 23 percent are associated with audit-client relationships of three years or less. Deis and Giroux (1992, 474) and Giroux et al. (1995, 76) also indicate that audit quality declines with the length of auditor tenure. These investigations generally have assumed simple associations between tenure and professional conduct (usually independence), as well as between professional conduct and audit quality. Consequently, a simple causal relation between auditor tenure and audit failure is implied. However, rotation supporters acknowledge that audit failures may be associated with factors other than tenure, suggesting that the link between longer terms and audit quality is not likely so simple or direct. A framework that accumulates and integrates the various 48 INTERNATIONAL ACCOUNTING, AUDITING & TAXATION, 8(1) 1999 elements associated with the tenure-audit quality issue likely will assist both researchers and accounting professionals in addressing the compulsory rotation question. Moreover, such a structure represents a necessary first step towards future model development and empirical investigation. The framework outlined in this paper synthesizes the relevant audit tenure and quality literature and considers anecdotal arguments both in favor of and against rotation. In doing so, it specifically incorporates both micro and macro economic influences relevant to the debate. Framework development begins with a general discussion of audit quality and its determinants. Next, the potential associations among audit quality, performance, and tenure are discussed. The paper then reviews the possible endogenous relations of economic incentives and market structure with perfor- mance and tenure. A summary of the proposed framework’s major constructs and related professional factors is presented in Table 1. Determinants of Audit Quality Proponents of compulsory rotation view it as a means to reduce the likeli- hood of audit failure. However, audit failure is simply the observed outcome of TABLE 1 Summary of Constructs and Related Professional Factors Constructs Professional Factors Audit Quality Ability (Detection) Technical competence Knowledge (training, education) Experience (professional, industry, client-specific) Adaptability Technological proficiency Professional Conduct (Reporting) Independence Objectivity Integrity Due professional care Conflicts of interest Judgement Economic Incentives General (fees, costs, profits) Efficiency Innovation Management advisory services Litigation Market Structure Competition (market share, concentration) Supply and demand Entry barriers (economies of scale, product differentiation and diversification) Professional regulatory mechanisms Auditor Tenure Length of audit engagement 49The International Debate Over Mandatory Auditor Rotation poor audit quality. DeAngelo (1981a, 115) defines audit quality as the probability that an auditor will both discover and truthfully report material errors, misrepre- sentations, or omissions in a client’s accounting system. The probability of discovering (detection) such breaches depends on an auditor’s technical compe- tence or ability (Deis & Giroux, 1992, 464). Prior studies have suggested that the probability of reporting is a function of independence (DeAngelo 1981a, 116; Raghunathan et al., 1994, 35), honesty (Watts & Zimmerman, 1981), and integrity (Johnson & Lys, 1990, 281). Therefore, this paper views the probability of reporting errors as dependent on a much broader concept: the auditor’s profes- sional conduct. This approach allows the framework to encompass such additional factors as independence, objectivity, due professional care, conflicts of interest, and judgment, all of which are cited by the U.S. accounting profession as critical to ensuring the public trust (AICPA, 1991, 4–12). DeAngelo (1981a, 116) indicates that the probabilities associated with de- tection and reporting are unlikely to be separable. Deis and Giroux (1992, 464) note that prior audit quality studies generally assume auditor competence, and focus on only one professional conduct factor: independence. 16 However, they acknowledge that without information about the auditor’s technical capabilities, the complex set of interrelationships between auditor performance and audit quality cannot be fully understood. Previts (1985, 155) confirms that indepen- dence, skill and legality, professionalism, and adaptability play major roles in the attest function. Therefore, this paper depicts audit quality as a function of two broad performance constructs: ability and professional conduct. Yardley et al. (1992, 153) indicate that the audit firm’s performance is a function of economic considerations (fees, costs, profits), efficiency, and innova- tion. Raghunathan et al. (1994, 37–38) argue that economic incentives may influence both detection and reporting. They propose that large, fee-paying clients are likely to be more difficult to audit, resulting in an increased likelihood of a failure to detect financial statement errors, despite adherence to professional conduct standards. They also suggest that the possibility of being terminated by a client could affect an auditor’s reporting decision. Consequently, the proposed framework includes economic incentives as a factor influencing auditor perfor- mance, specifically both ability and professional conduct. Both sides of the rotation debate argue that such a policy will affect competition. Potential cost increases associated with rotation could increase fees, lead to price cartels, and reduce competition. Alternatively, restricting auditor tenure might promote increased fee competition if clients are less able to dis- criminate between the audit quality of different firms. Proponents point to the Italian experience as evidence that competition increases with rotation. However, the Spanish market provides evidence to the contrary. Nevertheless, these expe- riences suggest that audit market structure must be considered in any attempt to explain the audit function. Elitzur and Falk (1996a, 260) concur, acknowledging that supply and demand may play a role in planned audit quality. Additionally, 50 INTERNATIONAL ACCOUNTING, AUDITING & TAXATION, 8(1) 1999 DeAngelo (1981b, 189) relies on competitive pressures to provide auditors with economic incentives to reduce audit quality. Therefore, the proposed framework includes a construct to capture market structure influences on both auditor performance and audit quality. To summarize, this paper argues that audit quality is a function of two performance constructs (ability and professional conduct) each of which may be affected by an auditor’s economic incentives. Market structure also interacts with both auditor performance and audit quality. The following sections describe the interrelationships among these factors in the context of the compulsory rotation issue. Figure 1 depicts the conceptual framework of the tenure-audit quality relation proposed by this paper. Performance Determinants Ability. Since the probability of discovering irregularities in a client’s system of accounting depends on an auditor’s capabilities, ability must be con- sidered when examining the compulsory rotation issue. In fact, the first general standard of U. S. auditing states that “the audit is to be performed by a person or persons having adequate technical training and proficiency as an auditor” (AICPA, 1972, AU Section 150.02). Deis and Giroux (1992, 464) argue that information about the technical capabilities of an auditor is critical to distinguishing between professional conduct (i.e., independence) and ability. This construct is intended to include such aspects of auditor ability as knowledge (e.g., training, education), experience (e.g., professional, industry, client-specific), adaptability, and techno- logical proficiency. Empirical research results suggest that auditor ability is positively associated with audit quality (path B3 F, Figure 1). St. Pierre and Anderson (1984, 256) show that 72 percent of audit litigation cases allege a problem with the auditor’s interpretation of accounting principles or auditing standards, or allegations of fraud. The auditor’s ability to address complex accounting issues seems particu- larly critical to ensuring audit quality. For example, both Stice (1991, 530) and Feroz et al. (1991, 112) document relationships between companies with complex financial accounting issues (receivables and inventory) and some type of problem audit (suits against auditors and SEC enforcement actions, respectively). 17 Opponents of compulsory rotation contend that it will hinder specialization, thus reducing auditor expertise (European Accountant, 1995b, 7). 18 O’Leary (1996, 21) indicates that an auditor’s client-specific knowledge grows as the length of the relationship increases. These arguments suggest a positive relation between tenure and ability or expertise (path A3 B). 19 Elitzur and Falk (1996b) also suggest that longer tenure periods motivate the auditor to introduce techno- logical improvements. Petty and Cuganesan (1996, 41) note that clients may change auditors if they become dissatisfied with the quality of technical advice provided during an engagement. This suggests that ability also may be a positive influence on tenure (path B3 A, Figure 1). 51The International Debate Over Mandatory Auditor Rotation FIGURE 1. Tenure-Audit Quality Framework. Note: Table 2 provides a detailed description of major path relations presented in the conceptual framework. [...]... International Debate Over Mandatory Auditor Rotation 59 Additionally, the resulting structure implies that all auditors have the same probability for audit failure, as well as for being discovered Moreover, all auditors are assumed to have the same expected penalty when an audit failure is discovered by a third party Future rotation studies may wish to address the expected cost of audit failure and its behavior... attention has been devoted to quantifying rotation s benefits or associated costs Several questions remain The International Debate Over Mandatory Auditor Rotation 61 that must be answered before mandatory auditor rotation can be considered for adoption: (1) what will mandatory auditor rotation cost the profession and its clients; and (2) will the benefits of such policy exceed the estimated costs? Additionally,... Italian managing partner, mandatory auditor rotations contributed significantly to the the firm’s growth rate of 31 percent in Italy during 1994 (European Accountant, 1995c, 11) Managing partner Andrea Ruggeri indicated “we won a lot of clients under the rotation of auditors,” and he cited the case of Mondadori, a large publishing company, which under Italian company law was required to change its auditor. .. that the association between tenure and competition may be either positive or negative (path A3 E, Figure 1) Yardley et al.’s (1992, 166) discussion of product differentiation also reveals possible causal relations between audit quality and market structure, as well as The International Debate Over Mandatory Auditor Rotation 57 between market structure and auditor tenure Specifically, they cite DeAngelo’s... be evaluated If a linkage between tenure and audit quality is confirmed after consideration of mediating factors, researchers then can evaluate the effects of restricting auditor tenure on performance and audit quality Proponents of mandatory rotation argue that long-term engagements reduce auditor objectivity and independence and can ultimately cause audit failure To test this assertion, researchers... Finally, the AICPA argues that the profession’s costs will increase if rotation is adopted However, it is unclear as to whether the increased cost will be shared uniformly by large, medium, and small auditing firms alike This may be an important issue if research shows that mandatory rotation and existing professional oversight controls are duplicative rather than complementary Currently, the AICPA requires... researchers may wish to examine the conditions under which these circumstances can be expected to hold and how factors such as competition are affected The impact of national and cultural differences on the framework s assumptions also can be evaluated 58 INTERNATIONAL ACCOUNTING, AUDITING & TAXATION, 8(1) 1999 TABLE 2 Primary Path Relation Summarya Path Flowsb Expected Associationsc A3 B NP None A3 C... that auditor experiences affect their cognitive representations Therefore, a positive association between these two performance factors is shown (path B3 C, Figure 1) Mautz and Sharaf (1961, 5) and Raghunathan et al (1994, 40) indicate that over a long association with a client, the auditor may become less challenged and less likely to use innovative audit procedures, or may fail to maintain an attitude... anecdotal arguments common to the rotation debate, this paper outlines a tenure-audit quality framework to assist both researchers and professionals in addressing the compulsory rotation issue Although theoretical support does not exist for many of the arguments asserted in practice, this framework adds structure to the compulsory rotation debate that may assist researchers in developing hypotheses in the. .. reveals that close personal relationships between auditors and their clients also can adversely impact audit quality as in the case of Deloitte, Haskins & Sells and AWA Ltd., an international trading company During AWA’s 1986 audit, the engagement partner became aware of problems in the company’s foreign exchange department which he suppressed at the request of his close, personal friends, the company’s . The International Debate Over Mandatory Auditor Rotation: A Conceptual Research Framework Anthony H. Catanach Jr. Paul L. Walker This paper contributes to the recent international debate over. their relations with performance and tenure. The proposed framework 6 1The International Debate Over Mandatory Auditor Rotation suggests that evaluating the efficacy of mandatory auditor rotation. audit quality. 5 5The International Debate Over Mandatory Auditor Rotation Audit Market Structure In organizing the existing rotation arguments, this paper’s framework as- sumes that (1) demand and