Would audit quality improve if companies were required to change financial auditors on a regular basis? That is the question facing federal regulators and the Council of Institutional Investors, and research conducted at Colorado State University’s College of Business may help provide some answers.
Jeff Casterella and Derek Johnston, associate professors of accounting at CSU, examine the issue of mandatory audit firm rotation in their paper, “Can the Academic Literature Contribute to the Debate over Mandatory Audit Firm Rotation?” published in the most recent issue of Research in Accounting Regulation (2013).
Their findings have important implications for the SEC’s Public Company Accounting Oversight Board (PCAOB) as it considers regulatory measures to enhance auditor independence and audit quality. The Council of Institutional Investors, whose members have combined assets that exceed $3 trillion, also asked the professors for permission to use the manuscript to inform its members about the mandatory audit firm rotation (MAFR) debate.
“I am pleased that our research could be helpful, especially on a national level,” Casterella said. “Both the PCAOB and CII have expressed significant interest in this work.”
The PCAOB is considering requiring audit firms to rotate off client engagements after a certain number of years as one way to increase auditor independence. In August 2011, the PCAOB issued a "concept" release on auditor independence and audit firm rotation. Two public meetings to solicit the public’s views on the topic have generated further discussion and debate.
Proponents believe MAFR would force a “fresh look” at company financial statements when a new audit firm rotates in, thereby improving audit quality. Opponents believe the new audit engagements would be less effective because a new auditor will lack the client-specific knowledge that is gained over time. For this reason they believe a move to MAFR would not only be costly but also end up diminishing audit quality.
Most academic research shows that audit quality is higher when there is a longer auditor-client relationship, a finding that would seem to mitigate against a policy of MAFR. However, most of these studies use data from a regulatory regime in which changing auditors is voluntary (as is currently the case in the United States). As a result, it is unclear that these results would extend to a regulatory arrangement where audit firm rotation is mandatory.
The review of the literature by Casterella and Johnston compares studies based on voluntary auditor changes with those that are based on mandatory auditor changes. They find that the conclusions reached about the possible effectiveness of MAFR depend on the type of data used, suggesting that federal policy makers should exercise caution when drawing inferences from academic research.
“We find that there is little or no support for MAFR in studies that rely on voluntary changers,” Johnston said. “On the other hand, when studies use mandatory [or quasi-mandatory] rotators, there is at least mixed support for a move to MAFR. While most of the studies that rely on mandatory rotators are supportive of MAFR, overall the results are still mixed.”
As a result of their research, Casterella and Johnston do not think the decision whether to implement MAFR nationally is clear.
“Thankfully, it is a decision Jeff and I don’t have to make,” Johnston said. “As academics, our job is to present unbiased studies and data that provide useful information to regulators.”
Casterella teaches a masters of accountancy class in the Colorado State College of Business that covers such big-picture, regulatory issues. The students learn how to relate data-driven research articles to various public-policy regulation debates in accounting.
“The class is a lot of work for the students and the studies they read are complex,” Casterella said. “But the students tell me they enjoy the challenge and learn a lot about the many regulatory aspects of the profession they are entering.”
Casterella, J. R., & Johnston, D. Can the academic literature contribute to the debate over mandatory audit firm rotation? Research in Accounting Regulation (2013), http://dx.doi.org/10.1016/j.racreg.2012.11.004