Mandatory Auditor Rotation: a Way for Regulator to Prevent Audit Failures?

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  • Topic: Audit, Big Four auditors, Auditing
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  • Published : May 8, 2013
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MANDATORY AUDITOR ROTATION: A WAY FOR REGULATORS TO PREVENT AUDIT FAILURES?

1. Introduction
Auditor rotation has long been a subject of debate as a measure to prevent audit failures, especially after the financial crisis. Two types of rotation suggested are firm rotation and audit partner rotation. Mandatory auditor rotation limits the number of consecutive years that a registered public accounting firm or audit partner can serve as the auditor of a company, and is claimed to be able to enhance audit quality and reduce market concentration. The purpose of this paper is to identify, consider and evaluate the impacts of mandatory auditor rotation on audit quality and market competition and, accordingly, conclude whether mandatory auditor rotation is the way to prevent audit failures. 2. Mandatory auditor rotation in the world

Different countries have different approaches towards mandatory auditor rotation. Some countries such as Australia, Canada, Denmark, Germany, Spain, etc. have adopted audit partner rotation rather than audit firm rotation. Some countries such as Pakistan, Italy and Oman have adopted audit firm rotation only for clients in specific areas such as listed companies, financial institutions, banks and insurance companies and governmental companies. On the other hand, a large number of countries previously implemented but have now abolished mandatory rotation. For example, Spain abandoned audit firm rotation in 1995 (Ewelt-Knauer et al., 2012). In August 2011, Public Company Accounting Oversight Board (PCAOB) issued concept release on auditor independence and audit firm rotation but still struggle to see if it will adopt a mandatory audit firm rotation requirement for the U.S. public company auditors. In September 2012, the European Parliament discussed a rotation period of twenty years, however no final decision has been reached so far. 3. The impact of mandatory auditor rotation on audit quality a. Arguments for mandatory auditor rotation

APB’ Ethics Standard (ES) 1 “Integrity, objectivity and independence” identifies six broad “threats” to auditors’ independence. Amongst those, familiarity threat is believed to be generated by long tenure when an auditor is over-familiar with the client and does not sufficiently question the audited entity’s point of view. The rotation of partners is considered to be one of the most influential factors enhancing independence, which could be impaired by long-time tenure (Beattie et al., 1999). Elitzur and Falk (1996) show that known and finite audit engagement periods jeopardize audit quality over time and the last period has the lowest level of audit quality. This is the consequence of auditors becoming excessively familiar with their clients, hence, “not exhibiting sufficient professional skepticism” (Arel et al., 2005). In contrast, new auditors bring a “fresh look” and different perspective to the financial statements. The case of Enron and Andersen is a magnificent example. As well as this, Arel et al. (2005) also worried that the staleness and redundancy lead to the tendency to anticipate results and base them on prior year’s findings. Moreover, eagerness to please the client exists in long-term tenure such as negotiation for potential long-term audit fees and unconscious desire to please the client. Mandatory rotation could help to remove these problems. In an experimental study, Nicholas et al. (2000) also concluded that rotation can increase auditor independence either as a stand-alone rule or in conjunction with mandatory retention. b. Arguments against mandatory auditor rotation

The key disadvantage of mandatory auditor rotation is the loss of the current auditor's cumulative knowledge of the company's business, processes, systems, people, and risks (PwC, 2012). These experience and knowledge is essential to a high quality audit and audit quality “tends to improve rather than worsen with tenure, providing support to the expectation that...
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