The Dark Side of the Audit Firm Rotation Rule
The implementation of the audit firm mandatory rotation rule has gained increasing importance since the European Commission has proposed it for all European listed companies. It is also considered as an option in the United States. A recent research investigates a true mandatory setting, Italy, providing evidence that rotation not only imposes higher costs in terms of higher fees but also does not seem to improve audit quality.
Mara Cameran, Antonio Marra and Angela Pettinicchio (Department of Accounting) together with Jere Francis (University of Missouri) have published Are There Adverse Consequences of Mandatory Auditor Rotation? Evidence from the Italian Experience in Auditing A Journal of Practice & Theory (online since January, 2014, doi: https://dx.doi.org/10.2308/ajpt-50663).
The main problem that mandatory rotation is supposed to solve is the close relationship that auditors can develop with clients in case of long tenure, which affects auditor independence and can lead to a lower level of audit quality. But evidence supporting rotation is scant. Therefore, the authors of the present study decided to investigate the potential negative effects of auditor rotation in a true mandatory setting. They selected Italy, where mandatory rotation has been required since 1975, and used data on audit fees and engagement hours.
The analysis is guided by the three possible negative consequences of mandatory rotation. First of all, since the ongoing auditor cannot be reappointed, the incentives to perform high-quality audits disappear, making the auditor shirk on effort and leading to lower-quality audits. Secondly, rotation might include switching costs to clients, such as larger audit fees. Lastly, the incoming auditor, lacking learning curve effects, might not be able to initially perform high-quality audits. The results from the Italian case show that for the outgoing auditor there is no lower-quality audits due to shirking in the final-year engagement, but, at the same time, he charges higher fees. This means that the auditor is likely to engage in opportunistic pricing. Looking at the incoming auditor, instead, the audit effort (in hours) is higher by 17% in the initial engagement while the initial fees are discounted by 16% respect to ongoing engagements. The higher costs suffered by clients would be acceptable if rotation improves audit quality. Unfortunately, the authors find that this is not the case.
Overall, the evidence provided by this study calls for attention when deciding to implement mandatory rotation. In particular, the authors highlight the case of countries with audit markets and clients larger than Italy, such as the United States. In that case the negative consequences might even be greater than in the Italian case. While in Italy the system works since it has not disrupted the audit market, in the United States a rotation rule might fundamentally change the way accounting firms are organized. To conclude, this study provides a useful guidance to policy makers, by helping regulators to better assess the consequences of fixed-term limits on auditor appointments.