The effect of mandatory audit firm rotation and tendering on investment decisions: the importance of corporate governance

       Audit firm rotation Klein

By Dr. Anna Gold, Dr Patrick Klijnsmit, Prof. dr. Philip Wallage and Prof. dr. Arnie Wright.

The primary objective of the audit profession is to provide reasonable assurance to investors, shareholders and other stakeholders that a company’s financial statements are free from material misstatements. To accomplish this goal, it is of prime importance that the auditor is independent from the audited company – both in mind and in appearance. Lack of auditor independence dramatically reduces or even nullifies the added value of an audit and can result in the loss of investor confidence in the financial information. Academics (e.g., Sikka 2009) and regulators claim that auditors played a significant role in the recent global financial crisis, for example by willingly ignoring clients’ questionable accounting choices. Inspections of audit firms carried out by the US-based oversight body the PCAOB often suggest that auditors lack sufficient professional scepticism. Hence, there is renewed interest among regulators in taking action to strengthen auditor independence. One frequently discussed threat to independence is long auditor tenure, i.e., the length of time that an auditor is engaged to audit a client’s financial statements. For example, the average auditor tenure of the 500 (100) largest companies in the US, based on market capitalization, is 21 (28) years (PCAOB 2011). The argument is that such a long tenure period may result in several independence threats. First, the auditor may become overly familiar with the client, potentially resulting in routine audits and lack of innovative and unexpected audit procedures. Second, lengthy tenure may cause incentives for the auditor to be reappointed. This situation, in turn, may encourage the auditor to acquiesce to client demands rather than maintaining a critical attitude, ultimately undermining independence.

The European Commission recently mandated a range of measures with the intention of mitigating threats to independence and improving audit quality. One of these measures entails limiting auditor tenure to a maximum period of ten years by mandating periodical replacement by another audit firm – a so-called mandatory audit firm rotation. This ten-year period may be extended by another ten years if a tender process is undertaken. Tendering entails putting the audit engagement up for competitive proposals by different audit firms, whereby the current firm may continue in subsequent years if selected. In contrast with rotation, a tender process provides opportunities for the incumbent auditor to be reappointed. The Netherlands is one of the first countries in the EU to implement mandatory audit firm rotation. The objective of our study was to examine the effect of these proposed auditor selection regimes on auditor independence. Professional ethical guidance (IESBA 2013) distinguishes between independence in mind (i.e., factual independence) and independence in appearance (i.e., as perceived by financial statement users). The focus of the current study is on the latter. It is argued that lack of independence in appearance is sufficient to undermine investors’ confidence in the audit and financial reporting (Fearnley and Beattie, 2004).

The focus of our experimental study was on the final year before a potential auditor change for a company being considered by professional investors as an investment opportunity. In our experiment, we held udit firm tenure constant and examined the effects that an upcoming mandatory audit firm rotation or tender would have on investors’ investment decisions, vis-à-vis the unregulated setting where the incumbent audit firm would be highly likely to be reappointed. While mandatory audit firm rotation and tendering potentially alleviate financial statement users’ independence concerns regarding familiarity threats (e.g., European Commission 2014), we posit that there are circumstances under which mandatory tendering could impact investor perceptions of the auditor’s motivations to please management in order to retain the client if there are contentious reporting issues at hand, i.e., a self-interest threat. However, we argue that such an effect may be dependent on the role of the company’s audit committee in the selection and appointment process of the auditor. Whilst corporate governance best practices prescribe that the audit committee should be an autonomous party in selecting and appointing the auditor (high audit committee autonomy), in practice, management may have a strong influence on this decision (low audit committee autonomy), potentially further threatening auditor independence. For instance, if management has significant influence over the audit committee’s selection decision, then investors are likely to view the auditor as strongly motivated to curry the favour of management to be reappointed, a problem which mandatory tendering would not be able to alleviate in the investor’s perception. On the other hand, tendering is expected to be highly effective in a high audit committee autonomy setting.

We examined 118 investment professionals’ investment decisions given three different auditor selection regimes (rotation, tendering, unlimited tenure) and two different levels of audit committee autonomy over the auditor appointment (low autonomy, high autonomy). Most importantly, our findings indicate that the likelihood of investing is positively affected by a mandatory rotation or tendering regime vis-à-vis unlimited tenure, but only when the audit committee has high autonomy (i.e., decisions related to auditor selection are made without significant interference by management). On the other hand, when the audit committee has low autonomy (i.e., management has influence over the audit committee’s selection of the auditor), we do not find support for our prediction that tendering would lead to the lowest likelihood of investing. Rather, an audit committee with low autonomy results in an equally low investment likelihood, regardless of the auditor selection regime in place. This result suggests that neither tendering nor rotation will be viewed by investors as effective in a weak corporate governance context. Thus, auditor selection regimes cannot be viewed in isolation of the corporate governance setting in which the regime will be embedded, which emphasizes the importance of an autonomous audit committee.

For further inquiries about the research project, please contact Dr. Anna Gold, anna.gold@vu.nl.

REFERENCES

European Commission. 2014. Regulation (EU) no. 537/2014 of the European Parliament and of the Council of 16 April 2014 on specific requirements regarding statutory audit of public-interest entities and repealing Commission Decision 2005/909/EC. Available at http://eur-lex.europa.eu/legal-content/EN/TXT/PDF/? uri=CELEX:32014R0537&from=EN.

Fearnley, S. and V. Beattie. 2004. The reform of the UK’s auditor independence framework after the Enron collapse: an example of evidencebased policy making. International Journal of Auditing 8(2): 117-138.

International Ethics Standards Board for Accountants (IESBA). 2013. Handbook of the Code of Ethics for Professional Accountants. IFAC: New York. Available at http://www.ifac.org/sites/ default/files/publications/files/2013-IESBA-Handbook.pdf.

Public Company Accounting Oversight Board (PCAOB). 2011. Concept release on auditor independence and audit firm rotation. PCAOB Release no. 2011-006, August 16. PCAOB: Washington, D.C.

Sikka, P. 2009. Financial crisis and the silence of the auditors. Accounting, Organizations and Society 34(6/7): 868-873.