Mandatory Audit Firm Rotation – a Literature Review

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Mandatory Audit Firm Rotation – A Literature Review

Since the passing of the Sarbanes-Oxley Act of 2002, much debate has occurred concerning mandatory auditor rotation for publicly held companies. Most corporate scandal involves dishonest or questionable accounting. This realization has brought about the priority to take more measures are taken to assure companies disclose the most reliable financial information. It is believed that a lack of auditor independence may be to blame for fraud as we have seen in recent years. The Sarbanes-Oxley Act of 2002 ordered an investigation of whether or not implementation of a mandatory auditor rotation policy could be beneficial. If this were to take effect it would require that companies obtain a new audit firm after a set number of years; possibly every five to seven years. Lately, some companies have voluntarily put policies in place to reflect this, even though it is not currently required by law (Daniels, 2009). Pros and Cons of Longer Auditor Tenure

There are several arguments against mandatory auditor rotation. Many point out that the longer an auditor has worked with a client firm, the more they know the business and the industry of their clients. This is supported by saying that this helps to assure a better more reliable audit. It is also worth noting that having a good audit-client relationship necessitates better communication, which is crucial in any business relationship. Although, opposition to this may believe that there is less scrutiny with longer tenure, the contrary is true, specifically with larger companies and their auditors (Anandarajan, 2008). Various studies have shown results that suggest short term auditor-client relationships may not be very beneficial. For example, some have shown that shorter auditor tenure is related to a higher amount of errors and thus, low quality audits. Also, one study from 2004 by Carcello and Nagy has shown that fraudulent reports are more likely to be filed within the first 3 years of an auditor-client relationship. Some research suggests that the longer an auditor services a particular client, the less likely the client company is to file bankruptcy. Changing auditors can be very costly for companies. Research has shown that when companies change auditors, they also often end up filing a restatement shortly after. Possibly this is because it has a new set of eyes looking at the information. At any rate, these restatements are shortening the money supply of companies (Daniels, 2009). Conversely, there are many research based arguments that support mandatory auditor rotation. Some claim that this is simply because extensive auditor tenure allows room for both auditor and clients to become lenient with policies. There has also been an ongoing concern that true auditor independence cannot be achieved because auditors are chosen and paid by the client company’s management (Raiborn, 2006). Additionally, many times the auditors are dealing directly with those in management while conducting their audit. This relationship is thought to create a conflict of interest which makes this type of reform much more complex than a requirement to change audit firms at regular intervals. Some also believe that increase turnover of auditors could affect the quality of companies’ audits. As stated earlier, there are increased restatements with an increase in auditor turnover. However, it is believed that if auditor rotation were adopted, over time the number of restatements should decrease as auditors will become more conscientious, knowing their work will be examined by the next auditor (Daniels, 2009). With regard to the costs associated with changing auditors more often than in the past, supporters reason that these expenditures will be a great deal less than costs incurred due to audit failure (Raiborn, 2006). Earnings Quality

There are several things that have been researched with regard to effect on earnings...
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