external rotation of the auditor
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Journal of Management ControlZeitschrift für Planung undUnternehmenssteuerung ISSN 2191-4761Volume 23Number 1 J Manag Control (2012) 23:81-91DOI 10.1007/s00187-012-0149-8
External rotation of the auditor
Patrick Velte
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J Manag Control (2012) 23:81–91DOI 10.1007/s00187-012-0149-8
O R I G I NA L PA P E R
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 2011the external mandatory auditor rotation (audit firm rotation) principally after six yearsas a reform measure to increase auditor independence, which could complement theinternal 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 givesa review of the empirical auditor change research. In contrast to the perception of theEC, the empirical results mainly don’t state an increased financial accounting andaudit 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 ac-counting 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 enhanceaudit quality by reducing the expectation gap (Liggio 1974), increasing auditor in-dependence and preventing further audit market concentration (Velte and Sepetauz2012, 9). In order to better auditor independence, based on independence in fact aswell as on independence in appearance, the EC is considering introducing mandatoryexternal 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, Germanye-mail: [email protected]
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cooling off period of four years. While internal rotation (auditor rotation) stipulateschanges within the audit firm, external rotation replaces the audit firm entirely, fol-lowing a fresh start approach (Weber 2005, 880). Currently Italy is the only state inthe EU with audit firm rotation rules (since 1974). Austria introduced external rota-tion for financial years beginning on January 1, 2004, but repealed it before it cameinto effect (Doralt 2008, 419). Similarly, compulsory audit firm rotation no longerexists in Greece and Spain.
Upon passage of the modified 8th EC directive (EC 2006), audit firm rotation wasnot codified due to, according to the EC’s assessment then, negative effects on auditquality were expected. For auditing bodies of public interest firms, compulsory inter-nal 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 coolingoff period of two years, the auditor in charge may reapprove his audit services with agiven client. Now, the EC discusses a one year increase of the cooling off period ofthe 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 oftwo years for all auditors who are primarily responsible for the mandate at hand orin 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 whoare in regular contact with the company’s administration, an extended rotation periodof 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 asvarious forms of rotation from an international point of view, this short review papercontains an agency theoretical foundation (low balling) and an analysis of the em-pirical 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 aswell as an inventory of empirical research on auditor change, the EC’s assumptionof a positive link between rotation and quality of financial accounting and auditingis to be discussed. The analysis is structured as follows: Sect. 2 includes an agencytheoretical 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 rota-tion on audit quality Sects. 2.2, 2.3). Subsequently, recent results of empirical auditorchange research will be discussed in Sect. 3, whereby the results differ between in-creased (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 (onetier system) or the management- and supervisory board (two tier system) and theirspecial relationship to the external auditor. This paper will dwell on the double-level
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principal agent theory according to Tirole (1986), which is most important in inter-national auditing research (Freidank et al. 2009; Velte and Weber 2011). The auditoracts as an “double agent” of the board and the shareholders. The relation between au-ditor and shareholder is hereby summarized in the gatekeeper function. Furthermore,an assisting role of the auditor results from his support for the audit committee withregard to the internal supervising of the management.
The traditional agency models do not provide for periodic or obligatory auditorchanges, with extreme cases allowing for indefinite mandates (Ewert 2003, 535). Thefamous low balling model of DeAngelo (1981a, 113) and its modifications are oftenmentioned in auditor change literature. The risks of an asymmetrical distribution ofinformation in audits can be magnified through the low balling phenomenon. Thelow balling effect, where the audit fees for the initial mandate as negotiated with theclient will not cover the actual costs, may have an impact on the auditor independenceand provide an incentive to form coalitions to the detriment of the public (DeAngelo1981a, 113). According to DeAngelo’s basic model (1981a, 113), the initial auditwill cause start up costs because the auditor will have to first familiarize himselfwith the business activities and environment of the company. Empirical evidence forsuch 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 competingauditors. Learning effects in follow up audits, which reduce audit costs, were foundempirically by Rubin (1988) and Roberts and Glezen (1990), among others. Theseinformation and cost advantages are an additional market entry barrier for competitorauditors in later audit periods (Quick 2002, 628).
The continuous increase in remuneration (fee cutting) through strategic marketconsiderations has a positive effect on quasi rents and strengthens the low ballingstrategy. A lack of fee cutting, however, does not necessarily mean that a low ballingstrategy was not utilized. Reversely, the presence of fee cutting is not necessarily ev-idence 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 thelate 1980s empirical evidence has increased, see Ettredge and Greenberg (1990),Turpen (1990), Gregory and Collier (1996) and Craswell and Francis (1999). Morerecently, the fee cutting strategy has become less attractive for audit companies be-cause mandatory declarations in the notes and in the transparency report of the auditcompany 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 reconstructiblefor clients (Simons 2011, 162). Marten (1994) had assumed a low balling tendencyon the basis of a survey among German auditors. Schatzberg (1990), Schatzberg andSevcik (1994) and Schatzberg et al. (1996) had found evidence of low balling throughexperiments, 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 consultingservices will experience a low balling effect on the combined offer of audit and con-sulting. Taking into account the spill overs between audit and consulting services, theabsolute economic advantage of the auditor is greater than if he limited his services
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to audits if the sum of training costs for the consultant and the consulting costs aregreater 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 motivationfor low balling and have an negative impact on auditor independence.
A further modification of the basic low balling model was submitted by Magee andTseng (1990), who add differences of opinion between client and auditor. Differencesof opinion originate in a conflict about (non-)acceptance of a certain questionable ac-counting policy. The economic advantage of maintaining the auditing assignment dueto positive transaction costs of the change is only incurring a restriction of indepen-dence if differences of opinion are of multi periodical nature, various types in theauditing industry regarding evaluation of accounting, the client is unable to distin-guish the type of the auditor, and the auditor himself knows his type only after theelection. Conflicts between management and auditor have an essential impact on lowballing and the quasi rents, because the management likes to assign an auditor, whodoesn’t submit a modified opinion (opinion shopping; Velte 2010).
Finally, Lee and Gu (1998) have established in their case that auditor indepen-dence is strengthened by low balling if the auditor receives his assignment directlyfrom the shareholders. In such a case, quasi rents have the effect of a security depositwhich is immediately withdrawn if malperformance occurs. Although in a stock cor-poration, 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 gen-eral assembly. Following Lee and Gu (1998), an accordingly positive effect of lowballing only occurs if the supervisory board acts on behalf of the shareholders at alltimes, 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 ofview there is normative restriction based on the auditor’s internal rotation cycle andthe necessity of annual re-election. The proposal contained in the EC green paperof 2010 (EC 2010), suggesting the responsibility of assignments to be transferred toan independent regulatory entity aims at the prevention of low balling which is berelated to setting a minimum audit fee and introducing a schedule of fees. But thisreform 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 toprevention of the auditor’s depending relationship with the management, distinguish-ing between the auditing of capital market oriented and non-capital market orientedcorporations. Since traditional agency conflicts are characteristic in large manage-ment operated corporations, the necessity of a statutory rotation is solely related tothis group of companies. Shareholders in small and medium-size companies are toexert greater influence on the management than an average private shareholder ina public company. This dichotomy in auditing standards has recently been contem-plated by the EC. Based on the legal approach in Switzerland (Kavan and Mueßig2011), “short cut” audit with low level scrutiny is being considered for small andmedium-size companies, in order to grant financial relief to the small firm sector.
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Burton and Roberts (1967) present a fundamental approach to the economic im-pact of auditor changes. Although, considering the assistant role of an auditor in astock corporation, a long-term contract between supervisory board and auditor seemssensible, the independence in appearance might be limited due to a special trust re-lationship between management and auditor in a long-term assignment. Burton andRoberts (1967) suggest that personal relationships between auditor and management,the combination of auditing and consulting, as well as the auditor’s goal of maintain-ing the assignment are determining factors towards reducing audit quality.
According to DeAngelo (1981a, 113), quasi-rents according to low balling with-out compulsory rotation might present a financial incentive to the auditor to give uphis independence, if the probability of exposure by the capital market is consideredto be low. According to supporters of this theory, an auditor’s low balling strategywhich might be related to his lack of independence can be counteracted by compul-sory rotation (Ewert 2003, 536). In opposite, Chi et al. (2004) state an adverse rotationeffect on auditor independence if the owners assign the auditor. The quasi rents canbe classified as a “pledge” according to Lee and Gu (1998). They point out that au-ditor independence is decreased in the last audit period before the rotation by hiddentransfers of the management. The auditor is not concerned any longer about the po-tential loss of quasi rents due to the non re-election by the shareholders. According toBigus and Zimmermann (2007), the absolute (client related), but not necessarily therelative quasi rents are cut short due to rotation, which implies that rotation does notnecessarily cause an increase of auditor independence.
Irreconcilable differences of opinion between management and auditor are notrisky to the auditor if a change is scheduled for the near future anyway, which ismentioned as another possible advantage. Literature assumes stricter and more re-lentless auditing under compulsory rotation, considering that the auditor wishes todiminish the risk of having his successor complain about his low performing uponreview 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 re-sults from previous years instead of anticipating important changes in the companydevelopment and adjusting his auditing strategy.
2.3 Increased auditing costs and effects on audit market concentration by externalrotation
The positive overall effects of compulsory rotation on the limitation and avoidanceof low balling as mentioned in literature are not secured, since compulsory rotationcreates system immanent disadvantages (Ewert 2003, 536). Thus, a change of theaudit form incurs a higher monetary value of auditing costs and increased audit feeswhich result in additional costs of the initial audit and transaction costs on the partof the client (Herzig and Watrin 1995, 795). Especially long-term audit schedulingand following up on complaints or auditors’ suggestions from previous audit periodswould have to suffer under rotation (Luik 1976, 239). Empirical surveys in the USshow that the auditor’s risk of liability is significantly higher in first or second auditsthan in following audits (AICPA 1992). Since first audits tend to be of lower quality,
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negative responses of the capital market are to be expected upon a forced change ofauditor. This way an investor can no longer distinguish a voluntary change of audi-tor due to opinion shopping of the management from a compulsory rotation, whichincreases his cost of information (Bigus and Zimmermann 2007, 19). Therefore, forcorporations which, according to Spence (1973), aim to offer high audit quality tothe capital market, compulsory rotation in short intervals may be unfavorable. Even astatutory long-term rotation cycle (e.g. more than nine years) cannot prevent essentialagency conflicts, e.g. the risk of hidden intention of management.
Audit market concentration is another important disadvantage of compulsory ro-tation, which the EC critically reviews in the current regulation draft. The Europeanaudit 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 lowballing. The reason for this concentration lies in the Big Four companies having thehighest experience value in auditing capital market oriented enterprises. Accordingto DeAngelo (1981b, 183) these audit firms tend to a higher quality and indepen-dence and have an extensive potential of resources in additional performances suchas advisory services to show. This development of oligopoly in the global audit mar-ket makes an entry into the market very difficult for small and medium-size auditfirms. In general, these difficulties cannot be overcome by compulsory rotation, sincechanges are made only between Big Four audit companies. Insofar, the EC wouldhave to introduce an obligation to assign a Non Big Four company after the exter-nal 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 strongerthan for internal auditor rotation. The overall impact of compulsory rotation is, froma theoretical point of view, uncertain. Even under low balling, the external rotationdoes not necessarily imply higher quality. The interruption or shortfall of learningand 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 financialaccounting and auditing, a number of variables are used, which if viewed separately,provide an assessment of limited informational value (Bedard et al. 2008). In gen-eral, earnings management is operated by means of discretionary accruals, accordingto paradigms outlined by Jones (1991) and DeFond and Park (2001). Audit quality isdetermined by diverging variables, e.g. based on restricted going concern opinions.Facing companies with substantial liquidity issues, an independent auditor tends torestrict 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 thereare either no effects or even negative effects on the quality of accounting and auditing
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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 inthe US, that in case of audit without external rotation it is more likely that the auditorover time biases approval testates accommodating the management, and concealserrors from the public. In the experiment at hand, however, experience effects of theauditor under a long-term assignment remain uncovered. Davis et al. (2009) showby 12,892 US corporations in the business years of 1991–1998 that the managementtakes advantage of its leeway in decisions and arrangements in short (two to threeyears) and very long duration of assignment (at least thirteen years) in order to fulfillor outdo result prognoses. The latter is considered positive by the capital marketand may reflect in a higher demand of shares. The authors state that the durationof the audit assignment has a positive effect on the extent of maximum earningsmanagement, so that the audit quality is increased by external rotation after a longerduration. Boone et al. (2008) point out signs of interdependence between externalauditor rotation and risk margin on allocated capital contribution in 12,493 surveys onthe US capital market during the business years of 1974–2001. Capital costs decreasein 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 ex-ternal rotation. Johnson et al. (2002) saw comparatively short assignments (two tothree years) causing higher training costs combined with a lower quality of account-ing in 11,148 US surveys during the business years of 1986–1995, while they did notfind proof of lower quality in long-term assignments (at least nine years). Myers etal. (2003) who surveyed 42,302 US corporations between 1988 and 2000 report thatauditors in long-term assignments (more than five years) tend to refuse a maximiz-ing earnings management. The auditor has a better knowledge about the managementstrategy due to learning and experience effects. Likewise, Al-Thuneibat et al. (2011)state a negative correlation between external rotation and the quality of accounting in358 Jordan companies listed at the stock exchange between 2002 and 2006. In theirsurvey of 35,826 or, respectively, 38,794 US corporations between 1990 and 2000,Ghosh and Moon (2005) show that investors, rating agencies and analysts assumepositive interdependence between the duration of assignment and the quality of ac-counting, represented by the interest rate investors require, rating results, as well asthe analysts’ performance prognoses. Contrary to their results with US students oninternal rotation, Gates et al. (2007) show that investors’ confidence in the financialaccounting quality in a regulatory environment with increased corporate governancemethods cannot be influenced by external auditor rotation. Furthermore, accordingto Carcello and Nagy (2004) based on the business years of 1990–2001, 267 UScorporations showed balance manipulations mostly in the first three years of the as-signment, since the management assumes lower quality of audit provided by newauditors. A long-term assignment (at least nine years), however, does not imply asignificant increase of balance manipulations.
Mansi et al. (2004), based on 8,529 US surveys between 1974 and 1998, questionthe usefulness of audit firm rotation and state negative capital market responses in
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the assessment of market-noted stocks of risk intensive companies. Therefore, withgreater entrepreneurial risk, investors tend to rate the auditor’s learning and experi-ence effects in a long-term audit assignment higher than possible limitations of hisindependence. Likewise, Knechel and Vanstraelen (2007) show based on 618 Belgiancompanies for the business years of 1992–1996 that independence in appearance ofthe capital market does not decrease with extended assignments. Azizkhani et al.(2007) see the duration of assignment in 2,033 Australian companies between 1995and 2005 which are audited by Non-Big-Four audit firms in an inverse relation tothe size of capital costs, whereas there are no significant changes under external ro-tation. Fargher et al. (2008) compare the impact of internal and external rotation on590 Australian companies during the business years of 1990–2004. They show thatin the first years after a change of auditor the management lowers the extent of ac-counting 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) survey117 US corporations with significant liquidity issues between 1996 and 1998 andobserve the probability of restrictions in going concern opinions to be lower in thefirst 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 1995and 2003 that the probability of restricted going concern opinions increases with theduration of assignments due to the auditor’s experience. According to Jackson et al.(2008), interdependence between the duration of assignment and the quality of finan-cial accounting cannot be established, so that the necessity of compulsory externalrotation is ultimately dismissed. In the case of the Spanish audit market, based on1,326 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 auditorchange increases the probability of restricted going concern opinions.
4 Summary
Auditor independence is an indispensable requirement in providing appropriate qual-ity of financial accounting and auditing. In order to strengthen auditor independence,the application of external auditor rotation is discussed. While in 8th EC directive of2006 internal rotation has been mandatory, the EC regulation draft of 2011 raisesquestions on the necessity of a compulsory external rotation principally after sixyears, which stipulates the change of the audit firm. Since the EC provides neithera theoretically nor an empirically founded economic justification for the reforms inquestion, the effect of external rotation on the quality of financial accounting and au-dit is uncertain. Due to this, the purpose of this analysis is to consult the low ballingtheory as well as recent results of empirical audit research and critically challengethe EC’s plans. An overview shows that an enhancement of auditor independencewill not necessarily be achieved by implementing external rotation. It might be paidfor by an interruption or lack of learning and experience. Even under application of
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low balling, the total effect of rotation on the quality of financial accounting and au-diting may be negative. Empirical studies mainly do not show an increased quality offinancial accounting and audit under changes of audit firms.
Regarding the empirical surveys mentioned above, it has to be pointed out that thefocus of empirical auditor change research is mainly on US, Asian, and Australiancapital markets, while only a few surveys exist on EU member states such as Belgiumand Spain. Furthermore, the variables used to estimate quality of financial accountingand 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 onthe part of the EC to perform cross-national empirical studies before implementingcompulsory external rotation throughout the EU. Furthermore, external rotation isconnected with other reform measures. The proposal of a multi-periodical assignmentof 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 regulationdraft and can have an impact on auditor independence in Europe.
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