Studying the Effects of Mandatory Audit Firm Rotation

by: Smith and Howard

January 12, 2016

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A recent academic study appearing in the American Accounting Association’s (AAA’s) Accounting Review challenges the idea that a long-term relationship between a company and its auditors compromises professional skepticism and quality. These findings are relevant to lenders who rely on audited financial statements.

Opposing points of view

For years, limits on audit firm terms have been debated. Regulators and investors tend to favor term limits, including those proposed by the Public Company Accounting Oversight Board (PCAOB) in 2011. Proponents argue that long-term relationships between audit firms and their clients lull auditors into a state of complacency — and cause them to accept questionable management decisions to preserve audit fees. Rules requiring periodic audit firm rotation would arguably enhance audit quality and independence.

The PCAOB set its 2011 proposal aside when it received about 700 comment letters from auditors, company managers, and audit committees that almost unanimously opposed mandatory audit firm rotation. They argued that term limits would add costs and make audits less efficient and more disruptive, without providing any benefit.

Psychology behind auditor skepticism

Last summer, the AAA published findings based on behavioral research conducted at several large universities. The research questioned the logic behind mandatory audit firm rotation.

The methodology was essentially an exercise in gamesmanship to evaluate the cause-and-effect relationship between term limits and auditor independence. During 90-minute experiments, college students were paired off and assigned the roles of auditor and corporate manager. Half of the participants stayed with the same partner for the entire experiment. The other half switched to new partners several times over 20 rounds.

The study found that, when the hypothetical “auditors” were skeptical (that is, they believed the manager was being dishonest), they were more likely to beef up audit procedures if they had stayed with the same partner than if they had switched partners. In other words, when the experiment mandated rotation, aggressive accounting practices were more frequently combined with low-effort auditing than with enhanced auditing procedures.

“Rotating auditors would find it difficult to garner psychological support for the probability of manager dishonesty, leading them to be less likely to choose high levels of audit effort than non-rotating auditors,” the AAA paper concluded.

Translation to real-world applications

A lender may question an auditor’s objectivity when a borrower stays with the same audit firm for many years, especially if the borrower is a private company that uses the same audit firm for tax and consulting services. But the AAA’s recent study should provide added peace of mind. It shows how long-term relationships can actually prompt auditors to closely investigate aggressive accounting practices and improve audit quality. 

Smith and Howard believes that long-term relationships with our clients enable us to provide exceptional value to them year after year. We gain a deep understanding of the business, its goals and operations and are able to provide advice and recommendations that are meaningful to the business. At the same time, we have a thorough understanding of and appreciation for the needs and requirements of bankers and lending institutions and provide the highest quality, professional and objective financial information possible. Our outstanding history of peer review results – the highest possible for each of our peer reviews in the firm’s history – is a testament to our quality and professionalism. We believe this combination of long-term commitment and objective, quality work should be the standard for all client/accounting firm relationships.

Have questions about audit firm rotations? Or, are you looking for more information on our commercial lender services? Contact Sean Taylor at 404-874-6244 or fill out our form below for more information.

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