Research Report The effects of audit firm rotation on perceived auditor independence and audit quality Bobbie W. Daniels a, ⇑ , Quinton Booker b a Jackson State University, College of Business, P.O. Box 17970, Jackson, MS 39217-06700, United States b Professor and Chairman, Department of Accounting, Jackson State University, MS, United States article info Article history: Available online 17 April 2011 Keywords: Audit firms’ independence Mandatory firm rotation Audit quality abstract Our study explores loan officers’ perceptions of auditors’ independence and audit quality under three experimental audit firm rotation scenarios. We use a case experiment with a between-subjects design to determine whether rotation of the audit firm impacts finan- cial statement users’ perceptions of auditor’s independence and quality. Findings based on 212 useable responses indicate that loan officers do perceive an increase in independence when the company follows an audit firm rotation policy. However, the length of auditor tenure within rotation fails to significantly change loan officers’ perceptions of indepen- dence. Findings also indicate that neither the presence of a rotation policy nor the length of the auditor tenure within rotation significantly influences the loan officers’ perceptions of audit quality. Published by Elsevier Ltd. Introduction Several audit failures (e.g., Enron, WorldCom, Sunbeam, and Waste Management) have prompted regulators to question whether external auditors are independent (Commission on Public Trust & Private Enterprise, 2003). Requiring audit firm rotation by limiting the number of consecutive years that a particular audit firm can audit a public company has been discussed as one means of improving auditor independence (AICPA, 1978; POB, 2001; SOX, 2002; U.S. Senate, 1976). The Sarbanes-Oxley Act (2002) requires the lead audit partner and audit review partner (or concurring reviewer) to be rotated every five years on all public company audits. Audit firm rotation is not a new concept. It has been implemented in several countries such as Israel, Brazil, Spain and Italy (Catanach & Walker, 1999). Several bills with provisions dealing with audit firm rotation were de- bated alongside the Sarbanes-Oxley Act (SOX) as a means of enhancing auditor independence. Nothing was enacted, but Congress decided further study was needed on the po- tential effects of mandatory rotation on registered public accounting firms. In this study, we examine whether loan officers perceive audit firm independence and audit quality is affected by an audit firm rotation policy. Background and research questions Over the years, practitioners and academicians have de- bated the pros and cons of long-term auditor–client rela- tionships. Some believe that the length of time an audit firm maintains a relationship with the client jeopardizes the public perceptions of auditor independence and audit quality. DeAngelo (1981b) defines audit quality on two dimensions: the market-assessed joint probability that auditors will discover a breach in the client’s accounting system; and the likelihood an observed breach will be re- ported. DeAngelo reasons that an auditor who has an eco- nomic interest in their client or lacks auditor independence will be less likely to report a discovered breach, thus reduc- ing audit quality (DeAngelo, 1981a). The AICPA issued a report, ‘‘Statement of Position Regarding Mandatory Rotation of Audit Firms of Publicly 1052-0457/$ - see front matter Published by Elsevier Ltd. doi:10.1016/j.racreg.2011.03.008 ⇑ Corresponding author. E-mail address: bobbie.w.daniels@jsums.edu (B.W. Daniels). Research in Accounting Regulation 23 (2011) 78–82 Contents lists available at ScienceDirect Research in Accounting Regulation journal homepage: www.elsevier.com/locate/racreg Held Companies’’ in 1992. The AICPA opposed mandatory rotation citing that mandatory audit firm rotation was not in the best interest of the public. According to this study, the AICPA examined 400 cases of audit failures be- tween 1979 and 1991 and found that audit failures were about three times more likely when the auditor was per- forming the first or second audit of that company. The study asserts that requiring firms to change auditors would increase the risk of audit failures because auditors would not have sufficient knowledge of the client’s business, which is important to identify problems early in a business (AICPA, 1992). James E. Copeland, the CEO of Deloitte and Touche, speaking before the U.S. Senate Committee on Banking, Housing, and Urban Affairs, indicated that rotation would increase start-up costs for auditors. He points out that requiring rotation of auditors would mean that institutional knowledge will be lost and on each new engagement the auditors will be climbing a steep learning curve (Copeland, 2002). John H.Biggs, Chairman and CEO of TIAA-CREF, which practices mandatory rotation, testified before the U.S. Senate Committee on Banking, Housing and Urban Affairs about the positive aspects of rotation for companies. According to Biggs, if Enron had been required to rotate its auditors every five to seven years, they would not have con- tinued to issue misleading financial information (Biggs, 2002). Furthermore, Biggs noted that rotation would also reduce low-balling of other non-audit services and elimi- nates the revolving door phenomenon (Biggs, 2002). SOX required the General Accounting Office to study the potential effects of mandatory audit firm rotation on public companies. GAO surveyed and interviewed accounting firms, chief fiscal officers and audit committee chairs of the Fortune 1000 publicly-traded companies. The majority of the largest public accounting firms and the Fortune 1000 companies interviewed agreed that the costs associated with audit firm rotation are likely to exceed the benefits. Many of the participants surveyed indicated that SOX’s requirements regarding audit partner rotation (using dif- ferent individuals within an audit firm) and auditor inde- pendence would achieve the same benefits as audit firm rotation (using different audit firms). GAO also interviewed other interested parties (consumer groups, institutional investors, accountants, etc.). Views of these groups were consistent with the overall views of other survey respon- dents interviewed by GAO. GAO acknowledges that it will take several years of experience with the implementation of SOX before the effectiveness of the act can be fully as- sessed (GAO, 2003). Research questions This study addresses two research questions. First, we address whether periodic rotation of the external audit firms would affect bank loan officers’ perceptions of exter- nal auditor independence. While this topic has been stud- ied, the answer remains unclear. Numerous researchers have addressed this topic by using accruals-based mea- surements, (Myers, Myers, & Omer, 2003), earning man- agement tools (Ghosh & Moon, 2005), financial reporting failures (Carcello & Nagy, 2004) and Judges’ perceptions (Jennings, Pany, & Reckers, 2006). Some researchers have argued that audit firm rotation appears to increase the per- ception of auditor independence (Arel, Brody, & Pany, 2005; Brody & Moscove, 1998; Jennings et al., 2006; Kemp, Reckers, & Arrington, 1983; Ramsey, 2001; Winters, 1978; Wolf, Tackett, & Claypool, 1999). However, because there are no regulatory requirement for audit firm rotation and 99% of the fortune 1000 public companies do not have a policy that requires audit firm rotation (GOA, 2003), archi- val data is not available for research in this area. Our exper- imental design circumvents the endogeneity problem. We do so by using an experimental design that manipulates (1) an audit firm rotation policy versus no rotation policy and (2) the effects of tenure within a rotation policy. The profession maintains that auditors must be inde- pendent ‘‘in fact’’ and ‘‘in appearance.’’ While both must be studied to understand independence, to research inde- pendence ‘‘in fact’’ requires information that is not publicly available. Prior researchers (Hill & Booker, 2007; Imhoff, 1978; Knapp, 1985; Lowe, Geiger, & Pany, 1999) have used perception to measure independence in appearance. Perception of independence is important as financial statement users rely on auditors to provide an unbiased opinion and to provide a level of confidence about the reli- ability of financial statements. The Commission on Public Trust & Private Enterprise’s (2003) report recommends that audit committees consider rotation of auditors as a means of enhancing auditor inde- pendence and building investor confidence. The Commis- sion believes that the cost of auditor rotation is less than the costs of crises in investor confidence. Accordingly, we develop the following research questions: RQ1a: Does the rotation of the external audit firm affect the bank loan officers’ perceptions of audit firms’ independence? RQ1b: What impact does the length of the auditor ten- ure within rotation have on the bank loan officers’ per- ceptions of audit firms’ independence? RQ2a: Does the rotation of the external audit firm affect the bank loan officers’ perceptions of audit quality? RQ2b: What impact does the length of the auditor ten- ure within rotation have on the bank loan officers’ per- ceptions of audit quality? Research methods We use a between-subjects experimental design for this research with three versions of a case. The versions of the case are different only as it relates to the rotation policy and length of tenure within the rotation policy. This sec- tion provides details on participants, data gathering and variables, and statistical methods. Participants Our population consists of one thousand bank loan offi- cers who were randomly selected from a database of more than 16,000 U.S. bank loan officers. We randomly assigned the loan officers to one of three versions of the research B.W. Daniels, Q. Booker / Research in Accounting Regulation 23 (2011) 78–82 79 instrument. We received 207 useable responses, represent- ing a response rate of 24.07%. The 207 responses are evenly distributes among the three experimental groups. Five respondents who failed the manipulation checks were re- moved from our analyses. The participants are comprised primarily of executives (77.9% – president or vice presi- dents). In addition, participants are mostly college edu- cated with 77% having baccalaureate degrees or higher. Finally, participants have significant experience, with 87% having over 10 years of banking experience and 67% having 10 years or more of bank lending experience. Data gathering and variables Each of the three experimental scenarios used involves a company’s audit firm rotation policy. The focus of the case is a material error in the pre-audit financial state- ments which management does not want to correct be- cause of the impact it would have on the firm’s current year financial statements. The audit firm rotation policy and length of tenure were manipulated. The rotation policy was either: the absence of an audit firm rotation policy (AFR0 hereafter); a seven-year rotation policy with one-year auditor tenure (AFR1 hereafter); or a seven-year rotation policy with six-year auditor tenure (AFR6 hereaf- ter). Loan officers were instructed to read the case materi- als, render their perceptions of the independence of the CPA performing the financial statement audit, and render a decision on the perception of audit quality. The independent variable (audit firm rotation) is the length of time the CPA firm has been performing the audit (22 years, seven years, or one year). The first dependent variable (independence) measures the confidence that the CPA firm performing the audit is independent. The sec- ond dependent variable (discovery), measures participants’ confidence that the CPA firm will discover the error. Both variables (independence and discovery) are measured on an eleven-point scale from ‘‘no confidence’’ to ‘‘extreme confidence.’’ The third dependent variable (report), mea- sures the perceived likelihood that the auditors would re- port the error. These variables are similar to those used in similar studies (Hill & Booker, 2007; Lowe & Pany, 1995; Lowe et al., 1999). Statistical methods We use univariate Analysis of Variance (ANOVA) to compare the means of each of the three groups for our independence question, the Scheffe’s post hoc test to test for differences among all possible combinations of groups, and chi-square analysis to compare proportions of ‘‘Yes’’ and ‘‘No’’ responses to the question concerning whether the audit firm should be allowed to do the audit. This dichotomous response question is designed to have the participant make a firm decision based on the perceived- level of independence recorded for the first question. Results The first research question asks whether the presence of an audit firm rotation policy impacts bank loan officers’ perceptions of auditor’s independence and quality. The re- sults are summarized in Table 1. ANOVA results for ques- tion Q1a indicate that the perceptions of auditor independence are significantly different among the three groups (F = 4.476, p < .05). These results suggest that respondents’ perceptions are influenced by the presence of an audit rotation policy. To compare the three groups, we use Scheffe Tests of Multiple Comparisons. The rotation groups are perceived as having a significantly higher level of auditor indepen- dence than the no rotation group (p < .05). The mean re- sponse of AFR0 is 5.65 and mean response for AFR1 and AFR6 are 6.70 and 6.77, respectively. Thus, a significant dif- ference in perceptions exists between a firm that has a rotation policy and one that does not. These results suggest that loan officers are more confident that the external CPA firm is independent when a rotation policy is present. The Table 1 Bank loan officers’ perceptions of auditor independence and quality. Group Independence a Discovery b Report (%) No Audit Firm Rotation (AFR0) 5.65 5.87 73.3 (2.38) (2.23) Audit Firm Rotation with one year tenure (AFR1) 6.70 6.30 85.7 (2.33) (2.43) Audit Firm Rotation with six year tenure (AFR6) 6.77 6.12 80.5 (2.39) (2.43) Significance of overall differences across groups p < .05 p = .584 p = .212 Pairwise Differences c AFRO versus AFR1 p < .05 p = .585 p = .297 AFRO versus AFR6 p < .05 p = .829 p = .519 AFR1 versus AFR6 p = .986 p = .897 p = .684 a Auditor Independence is measured on an 11-point scale anchored at 0 (no confidence) to 10 (extreme confidence). Significance of the overall difference in means are assessed using ANOVA: F-statistic (2 and 204 degree of freedom) = 4.476. b Discovery and report are use as proxy for audit quality based upon DeAngelo’s two-dimensional definition of quality. Discovery is measured on an 11- point scaled anchored at 0 (no confidence) to 10 (extreme confidence). Significance of the overall difference in means are assessed using ANOVA: F-statistic (2 and 204 degrees of freedom) = .540. Report represents the percentage of Loan officers who answered yes to the reporting variable. Significance of overall differences in the means is assessed using a v 2 test of proportions; X2 = 3.107. c Scheffe Test of Multiple Comparisons is used for pairwise comparisons. 80 B.W. Daniels, Q. Booker / Research in Accounting Regulation 23 (2011) 78–82 means for AFR1 and AFR6 do not differ significantly. Thus, findings fail to indicate a significant difference in percep- tion of auditor independence when the firm is performing the audit in the first year of a rotation policy versus in sixth year of a rotation policy. The second research question asks whether the pres- ence of an audit firm rotation policy impacts bank loan officers’ perceptions of audit quality (Q2a) and the impact, if any, of the length of the auditor tenure within rotation (Q2b). Results reveal no significant differences in loan offi- cers’ confidence that the auditors would discover the inventory error in the financial statements. The statistical findings suggest that the presence of a rotation policy or the length of the auditor-tenure within rotation does not influence the respondents’ perception of the auditors dis- covering errors in the financial statement. Finally, the rota- tion policy did not significantly affect the beliefs of the loan officers regarding whether the audit firm would report the error in its opinion. In summary, the perceptions of loan officers relative to discovering errors in the financial statement are only slightly modified when a company employs the same audit firm as compared to rotating their audit firms. Further- more, the length of the auditor tenure within a rotation policy fails to significantly change the loan officers’ percep- tions of audit quality. Conclusions, limitation, and future research Loan officers’ perceive that the presence of an audit firm rotation policy enhances the perceptions of auditor inde- pendence, but does not enhance perceptions of audit qual- ity. Further, increasing the length of the auditor tenure within rotation from a one-year period to a six-year period fails to significantly impact respondents’ perceptions of CPA firm independence. The findings in this study may be of interest to board of directors and audit committees in establishing policies regarding rotating the external auditors. Since rotating appears to enhance perceptions of auditor independence, publicly traded companies that have used the same auditor for years should consider whether they should voluntarily adopt a rotation policy. A key issue that must be addressed in deciding whether to rotate auditors is whether the benefits (i.e., greater per- ception of independence) exceed the costs (e.g., possibly higher fees, spill-over knowledge. The results of this study are limited to the perceptions of bank loan officers. Therefore, the results may not be gen- eralized to other groups. Secondly, our sample selection was limited to only one group of financial statement users. Perceptions of other users groups must also be considered. A third limitation is the realism of the scenario. In actual situations, loan officers would have had access to more information. Therefore, their decisions might have been different if additional information had been available. A fourth possible limitation stems from the possibility of nonresponse bias. We did conduct tests for non-response bias that did not indicate a problem. Finally, this study ap- plies to audit firm rotation in an environment whereas the board of directors has a policy of systematically changing auditors every seven years. It is possible that the results would not extend to a regulatory regime of mandatory audit rotation. 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RQ2a: Does the rotation of the external audit firm affect the bank loan of cers’. whether the pres- ence of an audit firm rotation policy impacts bank loan of cers’ perceptions of audit quality (Q2a) and the impact, if any, of the length of the auditor tenure within rotation (Q2b) percep- tion of auditor independence when the firm is performing the audit in the first year of a rotation policy versus in sixth year of a rotation policy. The second research question asks whether