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PCAOB Hears Evidence Favoring Auditor Rotation

Tammy Whitehouse | October 18, 2012

Audit research experts have presented the Public Company Accounting Oversight Board with evidence they say demonstrates auditor rotation leads to better audit quality.

During its Houston roundtable to discuss whether mandatory rotation would improve audit quality, Scott Whisenant, an associate professor of accounting at the University of Kansas, reviewed a variety of academic studies for the board that suggest rotation would produce benefits the board is seeking. He noted much of the protest around mandatory rotation has focused on costs, but few studies have focused on possible benefits because rotation is practiced in only a handful of countries.

The results of a 2000 study suggest, he said, that long-term auditor client relationships significantly increase the likelihood of an unqualified opinion, which raises questions about audit quality. The exception, however, is the last year of the relationship, when the likelihood of an unqualified opinion drops. “In this final year, the auditors finally drop the hammer down on clients,” Whisenant said, knowing they are about to surrender the job to a successor firm that will no doubt review their work.

Whisenant said his own more recent research with another coauthor suggests that in countries where rotation is practiced there's evidence of less earnings management, less managing to meet earnings targets, and more timely recognition of losses. The study concludes the quality of audit markets improves after the enactment of rotation, he says, and evidence suggests that concerns about any disruption or difficulty of transition to a new audit firm are more than offset by benefits. “Depending on the statistics we investigated, the benefit to audit quality of adopting rotation rules appears to be larger by a factor of at least two, and in some cases more, than the cost of audit quality erosion at the forced rotation of audit engagements,” he said.

Stephen Zeff, accounting professor at Rice University, told the PCAOB auditors have become more commercial and less professional over the past several decades, driven there by an education process that preaches memorization of standards more than critical thinking and an allowance for auditors to develop business relationships with their clients. Karen Nelson, another accounting professor from Rice, said her review of academic research suggests auditors working under the present model are more likely to issue a report biased toward management than under practically any other arrangement  that would involve mandates on rotation or retention.

PCAOB Chairman James Doty praised the “extraordinary array of views” presented by the academics. “This is where we we wanted to get to with the concept release,” he said, where the board could begin to digest empirical evidence that would suggest what regulatory regime is most likely to produce objective, professional, skeptical audits. The webcast archive of the Houston roundtable will be available on the PCAOB website.