An Empirical Investigation of Auditor Rotation Requirements SUZANNE LOWENSOHN,* JACQUELINE RECK,** JEFF CASTERELLA,* AND BARRY LEWIS* September 2007 Preliminary draft. Please do not copy or quote. ABSTRACT We add to the literature on mandatory auditor rotation by examining the Florida government audit environment in which there exist both rotation and non-rotation regimes and in which there exists an independent measure of the joint quality of the audit and of the financial statements of the reporting entity. In this environment we compare rotating entities with entities that have established long-term relationships with their auditors. We find that after controlling for other factors believed to be associated with report quality, governments that rotate receive higher quality reports. 2 1. Introduction The issue of mandatory audit firm rotation is once more in the forefront of the effort to improve auditor independence and to increase investor confidence in audited financial statements. The Sarbanes-Oxley Act of 2002 directed the Comptroller General to study the possible implementation effects of mandatory rotation. Although the GAO (2003) study indicates that mandatory rotation may not be the most efficient way to improve auditor independence, it did not rule out the possibility if Sarbanes-Oxley requirements do not have the desired effects. As happened in the past, parties are lining up on both sides of the issue. In a recent policy statement, the International Chamber of Commerce (2005) cited several adverse consequences of compulsory rotation of auditors, “…including negative effects on audit quality.” More recently, Glass Lewis & Co. (2007) issued a research report in which it recommended that audit committees adopt a 10-year rotation policy. The arguments for and against rotation are well-known by now, but evidence in support of those arguments has been anecdotal and/or flawed in several respects. There is no empirical support for the argument that rotation increases auditor independence by removing the incentive to sacrifice current judgments for the promise of long-term revenues from a client. And while there is substantial empirical evidence that audit problems are more prevalent in new or early audits, that evidence is from a regime that does not include a policy of periodic rotation. This paper provides an empirical analog to the Dopuch, King and Schwartz (2001) experimental finding that rotation can increase auditor independence. We analyze the government audit market in Florida to assess the effects of rotation on audit quality. This market has two key advantages for examining rotation. The first advantage is that some jurisdictions in Florida require rotation of auditors and still others have informally adopted such a policy. This means that the population of government reporting entities includes both rotators and entities that have opted to retain auditors on a long-term basis. The second advantage in this market is that the State Auditor General evaluates the quality of the audited financial statements of the reporting entities. This is a joint measure of the adherence to government auditing standards, generally accepted accounting principles, and Rules of the Auditor General. Using these data, we are able to compare financial reporting quality across the rotation and non-rotation regimes. Our results indicate that, after controlling for several variables thought to influence reporting quality, rotation is associated with a higher quality financial reporting system. The remainder of this paper is organized as follows. We begin with a brief review of recent research most relevant to the issues addressed in this paper. This is followed by a discussion of our data and the models and variables used to examine the effects of rotation. We end with a presentation of our results and some concluding comments. 2. Prior Research Numerous recent empirical studies have provided evidence that short-term auditor- client relations are fraught with problems and that long-term relations are either not problematic or are actually beneficial. Johnson, Khurana and Reynolds (2002) divided their sample of Big-6 audit clients into three audit firm tenure classification: short (2-3 3 years), medium (4-8 years) and long (9+ years). Using accruals-based measures of earnings quality, they find that short audit firm tenures are associated with lower quality of earnings relative to the medium group but find no evidence that long audit firm tenure leads to diminishing earnings quality. These results hold, as well, when the persistence of the accrual component of earnings is used as the dependent variable. Also using accruals as a proxy for earnings quality, Myers, Myers and Omer (2003) provide evidence that earnings quality actually increases with audit firm tenure. Ghosh and Moon (2005) add to this line of literature by using the earnings response coefficient as a proxy for the market’s perception of audit firm tenure. Their results indicate a positive relation between the market’s perception of earnings quality and tenure. They also find that as tenure increases, the influence of prior years’ earnings on earnings forecasts increases. Using a slightly different approach, other studies have documented problems with short audit firm tenure. In line with the accounting profession’s arguments against mandatory rotation, these studies examine audit failures, defined variously as fraud, SEC enforcement actions, and restatements. An early paper by Raghunathan, Lewis and Evans (1994) finds a higher incidence of SEC actions against companies who had recently changed auditors. Interestingly, they also find a slightly, but significantly, higher incidence for long audit firm tenures. A similar study by Walker, Lewis and Casterella (2001) finds that while short-term audits are more likely to be associated with audit failures, long-term failures are significantly more costly. More recently, Carcello and Nagy (2004) find that violations of Rule 10(b)-5 are significantly more likely in the early years of the auditor-client relationship. Similarly, using restatements as a measure of audit failure, Stanley and DeZoort (2007) also find a disproportionate number of failures in the early years. Only Deis and Giroux (1992) report conflicting results. Their study of Texas school districts finds that audit quality decreases with length of the auditor-client tenure. In summary, nearly all of these studies are consistent with the auditing profession’s claim that new audits are problematic because the auditors lack the institutional memory and experience with the client. We question the extent to which the existing body of literature can provide useful insights about the potential impact of moving toward mandatory rotation. Extant evidence in the United States comes from a regime that does not require reporting entities to change auditors periodically. Walker et al. (2001) document the fact that the short-term tenure group in their sample is comprised largely of voluntary switchers who differ significantly from a control sample on dimensions that would predict trouble. Most of the results above might be explained by a self-selection bias which has troubled companies either choosing to switch auditors or being dropped by their auditors. Two recent studies have bypassed this issue in clever ways and have produced a different set of insights into the rotation issue. Nagy (2005) examines auditor changes caused by the demise of Arthur Andersen. Nagy notes that this is not a perfect analogy to mandatory rotation because it is a one-time switch which has no pre-defined time horizon. Furthermore, the notoriety of the dissolution of Andersen put a spotlight of sorts on this group of clients. On the other hand, the sample of firms is much more likely to be similar to a control group than the sample of voluntary switchers discussed in Walker et al. above. In stark contrast to other studies using accruals as a measure of earnings quality, Nagy finds earnings quality improves after the switch, although for only the smaller half of the firms in the sample. Nagy attributes this finding to an increased 4 vigilance by the new auditor. For larger clients, he theorizes that the lack of a finite horizon may have given the clients more leverage over the new auditor. While not exactly a rotation regime, this natural experiment offers a unique opportunity to study a large number of mandatory auditor changes. Recognizing the difficulty of making cross-regime comparisons in the real world, Dopuch et al. (2001) use a laboratory experiment to examine the effect of mandatory rotation and/or retention on the independence of auditor-subjects across four different regimes. Independence in this case is operationalized as the auditor’s willingness to issue reports biased in the favor of the manager. The laboratory environment allows a much cleaner, but necessarily more abstract, test of the effects of rotation policies. The environment also allows the authors to precisely define the economic incentives facing both the auditors and the managers in the different regimes. Their results clearly indicate a higher level of auditor independence in the two regimes that included mandatory rotation. To summarize, other than Nagy (2005) and Dopuch et al. (2001), prior literature on rotation has lacked sufficient data to test empirically the effect of rotating some entities, but not others. The purpose of this study is to test directly the arguments for and against rotation. Regulators often suggest that reporting quality would improve if the number of long term auditor-client relationships were reduced by forcing a change in audit firm thereby increasing the number of newer, short term auditor-client relationships. On the other hand, the profession believes that newer, short term auditor-client relationships are problematic and have lower reporting quality. Therefore, they believe that long term auditor-client relationships should be allowed. With the data described next, we are able to inform the debate since we can isolate entities into the two distinct groups debated by regulators and the profession – entities with short term auditor-client relationships resulting from rotation policies, and entities with long term auditor-client relationships. Once the groups are identified we are able to contrast the financial reporting quality of the groups. 3. Research Approach 3.1 DATA We surveyed 451 finance directors of Florida local municipalities and counties regarding their current auditor, audit firm tenure, and auditor rotation policies. A total of 222 usable survey responses were received. 1 We then obtained a measure of the entities’ financial report quality and audit quality for the fiscal year ending September 30, 2003 from the State of Florida Auditor General’s Office. In accordance with Florida statutes, State Auditor General Office personnel use a checklist to review audited financial statements and audit reports annually for compliance with government auditing standards, generally accepted accounting principles, and Rules of the Auditor General. 1 Generally speaking, entities with a rotation policy would rotate before reaching an auditor-client relationship of 7 years. We received 7 survey responses indicating that a rotation policy was in place, yet the entities had auditor-client relationships of 7 or more years. In some cases, entities may have available a same auditor “renewal option” which can extend the length of the auditor- client relationship. Since it is not clear whether or not these 7 entities are clearly rotators they have been dropped from our analyses. However, inclusion of these entities does not significantly change the reported results. 5 We were provided access to the checklist and entity financial records to gather the joint quality measure, which we reconciled to publicly-available State Auditor General Office reports. Other variables, described below, were obtained from publicly available sources such as financial statements and information submitted to the Florida Auditor General’s Office, the Municipal Year Book (2005), and the Florida Department of Financial Services website. 3.2 MODEL The purpose of this research is to provide a better test of the effects of auditor rotation on report/audit quality. Carcello and Nagy (2004) acknowledged an important caveat to their results and the results reported in earlier studies. The caveat is that all prior empirical studies relied on auditor changes that were voluntary rather than auditor changes that were based on a rotation policy. In this study, we do not have that constraint since our data includes entities that have adopted a rotation policy. Table 1 describes our data in terms of rotation policy [yes/no] and auditor tenure [short/medium/long]. The proponents of audit firm rotation argue that entities should be rotated away from long term audit relationships to new short term audit relationships. In other words, they argue that rotation will shorten auditor-client relationships, and thus result in better audits. Rotating entities with short term auditor-client relationships are in Cell 1. On the other hand, the opponents of audit firm rotation argue that entities should not be forced to rotate audit firms but rather should be allowed to remain in long term audit relationships. In other words, they argue that long term auditor-client relationships are better. Entities with long term relationships are in Cell 5. To test these opposing arguments, our model compares the financial reporting quality of Cell 1 to that of Cell 5. Insert Table 1 about here The model we use is similar to that of Carcello and Nagy (2004) with adaptations made for government data: Comments = FC + Mgr + Growth + LnRev + B4 + ACom + RSHORT_LONG + e Where, Comments, the dependent variable, is the number of reporting deficiencies associated with the entity’s 2003 financial report from the Florida State Auditor General’s Office review checklist. A lower number indicates higher financial reporting quality. FC, financial condition, is an indicator variable denoting the existence of financial problems specified in the Florida statutes related to meeting long or short-term requirements; failure to pay creditors; failure to make employee-related payroll, tax or 6 benefit transfers; or fund balance and retained earnings deficits. Baber, Brooks, Ricks (1987) suggest that audit risk varies inversely with financial strength and, therefore, we expect financial problems to be associated with lower reporting quality. Given the nature of the dependent variable measurement, the predicted sign of the coefficient is positive. Mgr, is an indicator variable for entities which have a council-manager form of government. Prior research suggests that a council-manager form of government is consistent with greater demand for external monitoring (Raman and Wilson 1994, Zimmerman 1977) and higher reporting quality than other forms of government (Jensen and Payne 2005). Therefore, we predict a negative coefficient on this variable indicating that the council-manager form of government is associated with higher report quality. Growth measures the average annual growth in total revenue on a percentage basis for the period 1998-2003. We predict a positive sign, since rapid growth entities are more complex to audit (Francis and Wilson 1988) and should be associated with lower quality reports. LnRev, entity size, is measured as the natural logarithm of the entity’s revenues for fiscal year end 2003. We do not predict a sign, since there is conflicting evidence. Although Baber (1983) and Evans and Patton (1987) argue that demand for auditing increases with size, others find that audit quality as measured by oversight review is a decreasing function of size (Deis and Giroux 1992; O'Keefe and Westort 1992). B4 indicates that the entity is audited by a Big4 accounting firm. While Big 4 firms are generally associated with higher levels of reporting quality (DeAngelo 1981), this has not always been the case in governmental samples (Lowensohn, Johnson, Elder, and Davies 2007), therefore we do not predict a sign on this coefficient. ACom denotes the existence of an audit committee and is expected to be associated with higher quality reporting, consistent with Jensen and Payne (2005). RSHORT_LONG is the primary test variable which contrasts the reporting quality of recent rotators with that of non-rotator entities in long-term auditor relationships. This is done by assigning a value of +1 to rotators with auditor tenure of three years or less; a value of -1 to non-rotators with auditor tenure of seven years or more; and a value of zero to all other entities. Based on the experimental results of Dopuch et al. (2001), we expect short term rotators to be associated with better reporting quality than non-rotators with long tenures. 4. Analysis and Results 4.1 PRIMARY TEST Table 2 outlines the cell sample sizes for three levels of tenure and two levels of rotation. A traditional modeling approach would test the main effect of rotation [all rotators vs. all non-rotators], the main effect of tenure [for example all short term relationships vs. all long term relationships], and perhaps an interaction term. However, such modeling does not answer the long-standing argument about auditor rotation. For 7 example, the interpretation of the result for the main effect of rotation would be: across all levels of tenure, how do all rotators compare to all non-rotators. But the central argument is not about all rotators, it is about rotators in the newer auditor-client relationships. Furthermore, the argument is not about all non-rotators, but rather the non- rotators in long term relationships. Therefore, a rotation main effect variable is too coarse of a test. Similarly, the interpretation of the result for the main effect of tenure [short vs. long] would be: Regardless of rotation policy, how do all short term relationships compare to all long term relationships? Again, the central argument is not about all short versus all long relationships, it is about short relationships created by rotation versus the status quo, which are long relationships not affected by rotation. Lastly, an interaction term that crosses rotation [yes/no] by tenure [short/medium/long] would tell us how the effect of rotation is moderated, overall, by the effect of tenure. Here too, the interaction term is too broad based and is ill-equipped to test the policy effects of adopting a rotation policy. As indicated earlier, the key test of interest is focused squarely on Cells 1 and 5. Adoption of a rotation policy manifests itself by shifting audits from long tenure [Cell 5] to short tenure audits [Cell 1] (see Table 1). An a priori specific test of this type is best analyzed using a contrast coded variable. Buckless and Ravenscroft (1990) discuss the advantages of contrast coded variables. Other recent accounting studies that have used them for planned comparisons include Hales (2007); Hirst, Koonce, and Venkataraman (2007); Hammersley (2006); and Kennedy, Kleinmuntz and Peecher (1997). To compare Cell 1 to Cell 5 we use a contrast coded variable RSHORT_LONG. Cell 1 contains short tenure rotators and is coded +1 and Cell 5 contains long tenure non-rotators and is coded -1. All remaining cells (2,3,4) are coded as zero, and included in the analysis to improve the statistical power of our test. Using ordered logistic regression we regress the number of reporting deficiencies (Comments) on five control variables and the test variable RSHORT_LONG. Results are presented in Table 3. Insert Tables 2 and 3 about here The overall model is significant at p=.052 and our primary test variable (RSHORT_LONG) is negative and significant at p=.02 (one tailed). The interpretation is that entities that have recently rotated audit firms have significantly fewer deficiencies when compared to entities that do not rotate auditors and are in long tenure audits. This finding is consistent with regulators’ concern that long tenure audits have lower audit quality. In addition, two control variables are significant. We find that larger entities (Ln_Rev) are associated with fewer deficiencies at p<.004. Also, entities with a Big 4 auditor tend to have more deficiencies (p<.037), consistent with prior government research. 8 4.2 ADDITIONAL TESTS Several diagnostic tests were performed. All variance inflation factors are less than 1.4, and all condition indices are less than the cut-off of 30 recommended by Belsley, Kuh, and Welsch (1980), indicating that multicollinearity is not a problem. Outlier observations were identified for undue influence on our primary results. Removal of outliers does not change the result for RSHORT_LONG. A test for heteroskedasticity was also performed. The null of normally distributed residuals could not be rejected. Last, we increased the cutoff for long tenure to 9 years (consistent with Carcello and Nagy 2004). The results for RSHORT_LONG were consistent with the results in Table 3. We also ran a simple non-ordered logistic regression model where the dependent variable was coded as one if there were 1 or more deficiencies; zero otherwise. The results for RSHORT_LONG are the same as shown in Table 3 and significant at a p- value <.05 (one tailed). As a follow up test, we analyzed the same model after replacing the primary test variable with a new variable that contrasts short tenure non-rotators in Cell 3 (i.e. voluntary changers) with long tenure non-rotators in Cell 5. The results (not shown) indicate no significant difference between voluntary changers and long tenure non- rotators. The interpretation is that not all newer audits have higher financial reporting quality, only those under a rotation policy have higher financial reporting quality. 5. Conclusions By examining the Florida government environment, we were able to provide a real- world comparison of different audit regimes. In this empirical analog to Dopuch et al. (2001), we found support for their experimental results. 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[...]... state of Florida All variables are as follows Comments is the number of reporting deficiencies in fiscal year 2003 A lower number of comments indicates greater financial reporting quality RSHORT_LONG is coded as one for short tenure mandatory rotators, as minus one for long tenure non-rotators and as zero for all other observations FC is coded as one (zero otherwise) when there is diminishing fiscal solvency... fiscal solvency of a local governmental entity Mgr is coded as one (zero otherwise) if the entity has council manager form of government Growth measures average annual growth in total revenue on a percentage basis for the period 199 8-2 003 LnRev is the natural logarithm of entity’s fiscal year 2003 revenues B4 codes Big 4 firms as one (zero otherwise) ACom is coded as one if the entity has an audit committee... Ordered Logit Regressing Number of Comments on RSHORT_LONG and Control Variables for 222 Government Entities Predicted Chi-Square Variable Sign Coefficient p-value + 0.133 0.805 FC 0.089 0.733 Mgr + -0 .005 0.573 Growth ? -0 .186 0.004 LnRev + 0.957 0.037 B4 0.309 0.322 ACom -0 .373 0.020 RSHORT_LONG Model Likelihood Ratio 13.975 0.052 This table presents the results of an ordered logistic regression where.. .Rotation policy Yes No TABLE 1 Tenure by Rotation Policy Cells Short tenure Medium tenure (=7 years) not applicable Cell 5 TABLE 2 Tenure by Rotation Policy Cell Sizes for 222 Government Entities Short tenure Medium tenure Long tenure Rotation policy (=7 years) Yes 40 20 0 No 34 34 94 TABLE 3 Results of an. .. 199 8-2 003 LnRev is the natural logarithm of entity’s fiscal year 2003 revenues B4 codes Big 4 firms as one (zero otherwise) ACom is coded as one if the entity has an audit committee (zero otherwise) All p values are one tailed except for LnRev where a sign is not predicted 11 . KING; and R. SCHWARTZ. An Experimental Investigation of Retention and Rotation Requirements. ” Journal of Accounting Research 39 (2001): 9 3-1 17. EVANS, J. H., and J. M. PATTON. “Signaling and. years or less; a value of -1 to non-rotators with auditor tenure of seven years or more; and a value of zero to all other entities. Based on the experimental results of Dopuch et al. (2001), we. Review 69 (1994): 51 7-5 38. STANLEY, J.D., and T.F. DEZOORT. “Audit Firm Tenure and Financial Restatements: An Analysis of Industry Specialization and Fee Effects.” Journal of Accounting &