Investor Reaction to the Prospect of Mandatory Audit Firm Rotation
Joseph V. Carcello
University of Tennessee
Lauren C. Reid
University of Tennessee
February 25, 2013
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Investor Reaction to the Prospect of Mandatory Audit Firm Rotation
SUMMARY: The PCAOB is currently discussing the implementation of mandatory audit firm rotation in hopes of better aligning auditors’ interests with investors’ interests. Through the receipt of comment letters in response to the August 16, 2011 Concept Release, the Board has heard from important constituents including management of public companies, audit committee members, and audit firms. The PCAOB, however, received very few comment letters from investors. This study provides insight into investors’ views of forced rotation by evaluating the market’s reaction to this potential policy. The results reveal that most investors oppose mandatory firm rotation. In particular, investors are more opposed to forced rotation if the company in which they invest currently employs an industry specialistas an auditor, is a large public issuer, or utilizes a Big 4 auditor. Furthermore, investors appear to be opposed to mandatory rotation regardless of the tenure of the current auditor.
Keywords:mandatory audit firm rotation; market reaction; PCAOB; investor perception.
VERY PRELIMINARY – PLEASE DO NOT QUOTE OR CITE WITHOUT PERMISSION FROM THE AUTHORS
I. INTRODUCTION
“[I]n recent years, we have seen an equally significant spike in deficiencies. Year in, year out, inspectors find deference to management in key reporting areas. For example, in the critical area of fair value reporting of financial instruments, instead of skeptically testing the reasonableness of managements’ assumptions and resulting assertions, one firm’s method involved obtaining valuations from a number of external parties and picking the one that is, ‘closest to the pin’ – the pin being management’s claimed value.
… the explicit acknowledgement that the test was designed to support management’s number – the ‘pin’ – calls into question whether the auditor approached the audit with appropriate skepticism.” (PCAOB Chairman James Doty 2012).
As a result of the Public Company Accounting Oversight Board’s (PCAOB or Board) concern about auditors’ lack of professional skepticism, the Board has reopened a debate that began over thirty years ago and is considering whether indefinite tenure aligns the auditors’ interests with management rather than guarding investors’ interests. One commonly recommended solution to this issue is mandatory audit firm rotation.
Proponents argue that mandatory audit firm rotation results in management being less able to influence auditors’ decisions and auditors being less inclined to issue reports that favor management (Ruiz-Barbadillo 2009). Another common argument for mandatory audit firm rotation is that a new auditor provides a “fresh look” at the company and its financial reporting (Lu and Sivaramakrishnan2009). This different perspective can also improve audit quality and enhance independence. On the other hand, some argue that the loss of in-depth knowledge of the client and its industry reduces the effectiveness of the audit (Luand Sivaramakrishnan 2009). Opponents of forced rotation also believe that auditfirm rotation is unnecessary as appropriate safeguards are already in place, including audit partner rotation, audit committee independence, peer reviews, the normal turnover of engagement teams, threat of audit firm reputation loss, and risk of audit firm litigation (GAO 2003; Ruiz-Barbadillo 2009). Opponents also cite academic literature on auditor tenure that finds mixed results regarding the effects of long tenure on audit quality. Some of this research notes that audit quality suffers during the earlier years of the client relationship and leads to more instances of fraudulent financial reporting (Geiger and Rahunandan 2002; Carcello and Nagy 2004).
Mandatory audit firm rotation has recentlyreceived increased attentionwithin the United States as the PCAOB issued a Concept Release that presented the possibility of rotation, and initiated the process of examining its merits and drawbacks. While it is impossible to gather U.S. archival evidence on the effects of a potential policy, it is feasible to study whether or not investors might value the policy. By examining the U.S. stock market reaction to the August 16, 2011 issuance of the PCAOB’s Concept Release, weexamine how investors view the possibility of mandatory audit firm rotation. By studying investor reaction to this potential regulation,we provide insight into the perspective of the group, investors, that rotation is meant to protect. Furthermore, the PCAOB received well over 600 comment letters in response to the Concept Release (Franzel 2012), but less than ten percent were from investors and their responses were mixed. Therefore, it remains an empirical question as to whether investors support or oppose mandatory audit firm rotation. In addition to testing for an overall stock market reaction, weprimarilyinvestigate if investor reaction differs based on firm and auditor characteristics.The results of these additional analyses may be particularly informative to the Board as they reveal the possible triggers of investors’ reactionsto the prospect of mandatory audit firm rotation.
Overall, we find a significant and negative market reaction to the release of the Board’s Concept Release on mandatory audit firm rotation,suggesting that most investorsoppose mandatory audit firm rotation. Specifically, the mean cumulative abnormal return during the two days following the August 16, 2011 issuance of the PCAOB Concept Release is -2.53%., where the cumulative abnormal market return is calculated using an index of foreign stock returns since these firms would have been less effected by the issuance of the PCAOB’s Concept Release. In addition, even though we calculate abnormal returns using a foreign stock index, we do not have a U.S.-specific control group – all firms registered with the SEC would be affected by any change in PCAOB policy regarding firm rotation – therefore, we focus primarily on our cross-sectional tests. We examine whether there is a differential market reaction based on company size, audit firm industry specialization, Big 4/non-Big 4 dichotomy, and audit firm tenure. Based on these cross-sectional tests of firm and auditor characteristics, we find that large public issuers havea significantly more negative reaction to the prospect of mandatory rotation than smaller public issuers. Furthermore, firms with an industry expert as an auditor experience a significantly more negative market reaction than firms without an expert auditor. We also find evidence that firms audited by Big 4 accounting firms react more negatively to the discussion of mandatory rotation compared to firms audited by non-Big 4 firms. In addition, we do not find evidence that the market reaction differs for firms with long auditor tenure compared to firms with shorter auditor tenure.
This studycontributes to the debate on firm rotationbyprovidingthe PCAOB and other regulators with relevant and timely information regarding the market reaction to the Board’s Concept Release. As regulators are considering the implementation of this regime in order toprotect investors, it is interesting to note the negative market reaction to the possibility of mandatory auditor rotation.Furthermore, it appears that investors respond negatively to the discussion of mandatory rotation as they value the expertise of their current auditor and perhaps believe that any potential benefits of rotation, such as improved independence, would likely be outweighed by its costs. It also appears that investors view rotation as especially undesirable for large public issuers and companies utilizing a Big 4 auditor. In addition, this study indicates that investors did not react differently based upon auditor tenure, which is particularly interesting given the motivation to introduce rotation in order to curb independence issues related to long auditor tenure.
The remainder of the paper is organized as follows. Section II provides further background on mandatory audit firm rotation and develops ourhypotheses. Section III describes our research method, and Section IV presents our results. The last sectiondiscusses limitations and concludes.
II. BACKGROUND AND HYPOTHESES
PCAOB Consideration of Mandatory Firm Rotation
As stated previously, PCAOB Chairman Doty has expressed concern that long auditor-client relationships can create an incentive to please the client. This perverse motivation clouds the auditors’ judgment and can cause a lack of professional skepticism as well as a failure to obtain sufficient audit evidence. Doty believes that steps need to be taken to shift the auditors’ “mindset to protecting the investing public” and that “it is incumbent on the PCAOB to take up the debate about firm tenure and examine it, with rigorous analysis and the weight of evidence in support and against [it]” (Doty 2011).
As a result of Mr. Doty’s concerns, the PCAOBis consideringrequiring mandatory audit firm rotation in order to achieve “increased confidence in financial reports, if not outright improvement in the accuracy and completeness of these reports” (IAG 2011a).Also, certain members of the PCAOB’s Investor Advisory Group believe that it is appropriate to consider the issue of mandatory firm rotation as the financial crisis provided the “first test” of the effectiveness of SOX and, in the minds of some, auditors failed in ensuring the appropriateness of financial reporting(IAG 2011b).
On August 16, 2011, the PCAOB issued a Concept Release to solicit public comment on ways to enhance auditor independence, skepticism, and objectivity, including the introduction of a mandatory audit firm rotation policy. The Concept Release presented numerous questions regarding the benefits and costs of mandatory audit firm rotation and also requested input as to how such a policy would be implemented. The Board, for example, invited discussion as to whether rotation should only be required when auditor tenure exceeds 10 years and only for audits of the largest firms. The Board welcomed feedback on these issues and received an overwhelming number of responses from audit firms, public companies, audit committee members, academics, associations, and investors during the comment period. The document also discussed the common arguments that have been made for and against rotation over the years. The Board noted that firm rotation has often been dismissed by academics and professionals based upon the argument that audit quality is lower in the first few years of an engagement, but the Board points out that these studies and arguments are grounded in an environment where rotation is voluntary (PCAOB 2011).[1]
The possibility of mandatory firm rotation was discussed when Congress was drafting the Sarbanes-Oxley Act of 2002. However, Congress determined that more research was needed to see if audit partner rotation, among numerous other measures, was sufficient in addressing independence concerns. Therefore, Section 207 of SOX commissioned the Government Accountability Office (GAO) to study mandatory firm tenure limits. In 2003, the GAO issued a report stating that the SEC and PCAOB would need several more years to determine whether or not the SOX reforms provided enough protection for investors against entrenched audit firms. The GAO concluded that audit firm rotation ‘‘may not be the most efficient way to strengthen auditor independence and improve audit quality’’ (GAO 2003).[2]Over the past eight years, the PCAOB has conducted almost two thousand audit firm inspections (Hanson 2012)and has found several hundred audit failures (Doty 2011).As a result of continuing problems as revealed by inspection findings, the PCAOB is reconsidering whether mandatory audit firm rotation would improve audit quality.
Evidence in Favor of Mandatory Audit Firm Rotation
Proponents of mandatory audit firm rotation argue that long tenure impairs the independence of the auditor. This argument is grounded in the theory developed by DeAngelo (1981), which states that a client provides the audit firm with an annuity of quasi-rents that it expects to receive throughout its relationship with the client. This incentivizes the auditor to make sacrifices in order maintain the client relationship and guarantee its annuity, which can diminish auditor independence (DeAngelo 1981). Similarly, Gietzmann and Sen (2002) suggest that the ability of an audit firm to preserve its client relationships and thus its future audit fees can lead to implicit collusion[3] between management and the auditors.
Several behavioral studies have investigated the potential benefits and costs of imposing mandatory audit firm rotation, and these studies generally are supportive of audit firm rotation. Dopuch et al. (2001) experimentally test the effect of regulating firm rotation on auditor independence and find that such a policy decreases the auditor’s propensity to issue reports that please management and thus increases independence. In a similar vein, Wang and Tuttle (2009) perform an experiment to test the impact of rotation on the negotiation process between clients and auditors. The authors discover that in the absence of mandatory firm rotation, auditors are more concerned with appeasing management and tend to use “obliging” strategies in negotiation whereas with a mandatory rotation regime, auditors are less concerned about their relationship with management and tend to use “inaction” strategies (Wang and Tuttle 2009). Finally, Daniels and Booker (2011) find that bank loan officers view auditors as more independent when an audit firm rotation policy exists, although the presence of a rotation policy does not affect loan officers’ perceptions of audit firm quality. Conversely, in a study where MBA students were used as subjects to proxy for nonprofessional investors, Kaplan and Mauldin (2008) find that a rotation policy does not affect these subjects’ views of the extent of auditor independence.
Nagy (2005) collects data within the United States where a forced auditor change occurred, although not as a result of mandatory firm rotation. He uses the demise of Arthur Andersen to gather archival evidence on the effects of a mandatory audit change on audit quality. Using the absolute value of discretionary accruals as a proxy for audit quality, he finds that a forced change in auditors increases audit quality for relatively small companies (Nagy 2005). In addition, some local governments require mandatory firm rotation. For example, some jurisdictions in Florida require audit firm rotation whereas others do not. Lowensohn et al. (2007) find that financial reporting quality is higher in those Florida jurisdictions that require rotation as compared to those jurisdictions that do not.
While research surrounding mandatory firm rotation in the United States is limited, foreign settings where rotation is currently in place or once was implemented provide the ability to more directly study rotation’s effects.Chung (2004) examines companies in Korea before and after the passage of its mandatory rotation rule. The author reports lower discretionary accruals subsequent to the implementation of the requirement, which suggests that audit quality improved due to the enhanced incentives to maintain auditor-client independence (Chung 2004). Kwon et al. (2010) also study Korea’s mandatory audit firm rotation regime; however, Kwon et al. find different results. They find that audit hours and fees increased, but that audit quality (measured using abnormal discretionary accruals) remained unchanged or slightly decreased.
In addition, prior studies on auditor tenure and audit quality might provide some information on the benefits and drawbacks of audit firm rotation. However, it is important to carefully extrapolate from studies using regimes where auditor turnover is voluntary to regimes where auditor turnover would be mandatory (Casterella and Johnston 2013). Notwithstanding this caveat, there are a number of studies that examine auditor tenure and various financial reporting and market outcomes. Davis et al. (2009) analyze the relation between auditor tenure and earnings management in pre- and post-SOX eras. Davis et al. find that prior to the passage of SOX, auditor-client relationships lasting fifteen years or more are associated with higher levels of accruals earnings management (Davis et al. 2009). However, post-SOX, they find no significant relation between tenure and earnings management. This change in the relation between auditor tenure and earnings management might be due to auditor performance being more closely scrutinized post-SOX, and also due to an increased risk of regulatory action against auditors (Davis et al. 2009). Additionally, Dao et al. (2008) use voting on auditor ratification as a proxy for investor perceptions and discover a significant association between shareholders not voting or voting against auditor ratification and long auditor tenure, suggesting that investors view long auditor tenure negatively.
Evidence Against Mandatory Audit Firm Rotation
Opponents of firm rotation suggest that forcing auditors to be engaged by the same client for a relatively brief period would cause an overall decrease in audit quality as auditors with less exposure to the client do not have the necessary knowledge and expertise to ensure the appropriateness of the client’s financial statements (Moritz 2012).Elitzur and Falk (1996) attempt to model periodic rotation and find that a finite engagement period negatively affects planned audit quality until the last audit period. Comunale and Sexton (2005) model the effects of firm rotation on the market shares of public accounting firms and reveal the detrimental impact rotation has on auditor independence as well as quality. Kornish and Levine (2004) examine mandatory firm rotation from the audit committee perspective and argue that such a policy prevents the audit committee from using threats of dismissal to punish the auditor. More recently, Lu and Sivaramakrishnan (2009) provide a theoretical model that reveals the investment inefficiency created by a mandatory firm rotation regime.